Economic Substance and the Supreme Court

If an individual seeks a tax benefit under a congressionally-enacted statute, is a court obliged to examine that statute to determine whether he qualifies for that benefit? To many district and circuit courts, the answer to that question is a firm 'no.' This article argues that that approach is inappropriate and, despite the lower courts' assertion to the contrary, flatly inconsistent with applicable Supreme Court precedent.

Substance and the Court I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 969 Courts’ Approach . . . . . . . . . . . . . . A. Coltec v. United States . . . . . . . . . . . . . . 972 re Holdings . . . . . . . . . . . . . . . . . C. Compaq v. Commissioner . . . . . . . . . . . . . 974 D. United States v. Wexler . . . . . . . . . . . . . . 975 E. Summary . . . . . . . . . . . . . . . . . . . . . . . 976 Court’s . . . . . . . . A. Gregory v. Helvering . . . . . . . . . . . . . . . 978 B. Knetsch v. United States . . . . . . . . . . . . . 980 C. United States v. Consumer Life . . . . . . . . . 981 D. Frank Lyon v. United States . . . . . . . . . . . 982 E. Cottage Savings v. Commissioner . . . . . . . . 983 F. Portland Golf v. Commissioner . . . . . . . . . . 984 G. Landreth Timber Company v. Landreth . . . . 985 H. Summary . . . . . . . . . . . . . . . . . . . . . . 986 Recommended Approach . . . . . . . . . . . . . A. Extent of Substance . . . . . . . . . . . . . . . 986 B. Civil and Criminal Penalties . . . . . . . . . 991 C. Legislative Acquiescence . . . . . . . . . . . . 991 D. Underlying Purpose and Economic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I. Introduction The Supreme Court grants certiorari in a wide variety of fascinating cases. Occasionally, it agrees to decide tax cases, too. Perhaps because of the perceived dryness of tax law,1 hesitant to address the validity so-called economic substance doctrine.2 Although there are too many formulations of the doctrine to count,3 the lower courts often hold that even when a taxpayer has met a statute’s requirements,4 benefits unless his conduct reveals a business purpose and a reasonable expectation of profit.5 1See generally Neil M. Richards, ‘‘The Supreme Court Justice and ‘Boring’ Cases,’’ 4 Green Bag 2d 401 (2001) (describing various justices’ distaste for tax cases). 2See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231, Doc Cir. 1998), cert. denied, S. (1999); American Electric Power, Inc. v. United States, 326 F.3d 737, 2003 TNT Cir. 2003), cert. denied, 1043 (2004). 3See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988). (‘‘The casebooks are glutted with [economic substance] tests. Many such tests proliferate because they give the comforting illusion of consistency and precision. They often obscure rather than clarify.’’) 4See also John B. Magee and Gerald Goldman, ‘‘Uncut Gems: Judicial Review in Economic Substance Appeals,’’ Tax Notes, 6, 2007, p. 481, Doc 2007-16698, 2007 152-36. (‘‘federal courts have long required that transactions not only comply with the express requirements of the Internal Revenue Code, but also have economic substance to entitle the taxpayer to interest and other deductions.’’) For a discussion of various cases that have employed the doctrine, see infra Part II. 5See infra note 267 for other formulations of the doctrine. The doctrine sometimes goes by other names and often overlaps with other judge-made doctrines. See Joint Committee on Taxation, ‘‘Background and Present Law Relating to Tax Shelters,’’ Doc 2002-1891, 2002 TNT 154-23 (Mar. 19, 2002) (‘‘Amandeep S. Grewal lives inWashington. He is not currently associated with any law firm and the views expressed here are solely his own. He would like to thank Brian Galle, David Hasen, Brian Pandya, William Rothwell, Michael Schler, Robert Sherman, Ethan Yale, and Larry Zelenak for their comments on earlier drafts of this report. In their writings, Galle, Schler, Yale, and Zelenak have expressed completely different views of the economic substance doctrine from those presented here, and their willingness to comment on this report does not indicate their endorsement of its conclusions. Further comments are welcome and should be sent to andy.grewal@gmail.com. Grewal argues that the economic substance doctrine does not exist — at least not in the eyes of the Supreme Court. Although many lower courts have held that the economic substance doctrine can trump a taxpayer’s compliance with the code or justify a court’s refusal to examine statutory language, Grewal argues that the Supreme Court has never sanctioned that approach. Instead, says Grewal, the Supreme Court has examined economic substance principles only when the terms of the governing statutes make those principles relevant. Grewal concludes that the Court should affirm its prior holdings and instruct the lower courts that the casual disregard of statutory language is inappropriate. Copyright 2007 Amandeep S. Grewal. All rights reserved. next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. tax special report Economic Substance and the Frank Lyon v. United States Supreme Court Cottage Commissioner Golf v. Commissioner By Amandeep S. Grewal Landreth Timber Company Summary IV. Recommended Approach 986 Extent of Substance and Criminal Penalties Legislative Acquiescence Underlying Purpose and Economic Shams ... 993 V. Conclusion 996 Introduction Court grants certiorari in wide cases. it of the tax law,1 the Court has been hesitant to address the validity of the doctrine.2 Although are too many formulations of the doctrine to count ,3 ltohweer ofen hold that even when a taxpayer has met a statute's requirement s he cannot enjoy any of its conduct r,eveals a business 5 1See generally Neil M. Richards, "Justice 'Boring' Cases," 401 justices' distaste for tax cases). 2See, e.g., ACM 98-30659, 98 TNT 198-9 (3d Cir. 1998), cert. denied, 526 U.S. 1017 States, Doc 2003-10647, 2003 TNT 82-11 (6th Cir. 2003), cert. denied, 124 Sup. Ct. 1043 (2004). Table of Contents 3See Collins Commissioner, ("are glutted [economic substance] Many proliferate they give the comfort-1. ing illusion of consistency and precision. They often obscure II. Lower Courts' Approach ... 970 clarify.") 4See also John B. Magee and Gerald Goldman, "Coltec v. United States in Economic Substance Appeals," Tax Notes, B. In re CM Holdings 973 Aug. 6, 2007, p. 481, Doc 2007-16698, 2007 TNT 152-36. ("The Compaq Commissioner transactions United States the express requirements the Internal Revenue to ... deductions.") III. The Supreme Court's Approach 978 that have employed Gregory 5See infra note 267 for other formulations of Knetsch States by overlaps other judge-made doctrines. See on Taxa-United States v. Consumer tion, "Background and Present Relating to Tax Shelters," JCX-19-02, Doc 2002-1891, 2002 TNT 154-23 (Mar. 19, 2002) ("In (Footnote continued on next page.) TAX NOTES, September 10, 2007 969 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315Economic substance cases raise many difficult factual and legal issues, and one can understand why the Court might not wish to get involved. However, the lower courts’ creation of an economic substance doctrine contradicts Supreme Court precedent, has caused deep circuit with statutory interpretation. Given that the ‘‘judicially created’’doctrine is a ‘‘prerequisite’’ to the application of every code provision offering tax benefits,7 the Court holdings and courts that the casual disregard of statutory language in favor of judicial tests is inappropriate. the Court itself applies economic substance does governing statute makes those principles relevant. The lower apply economic substance principles regardless of what the code says (that is, they apply floating Through that has no statutory reference point, the lower courts have concluded that ‘‘mere compliance with the code’’8 is insufficient to enjoy tax benefits. that the lower courts’ application economic substance be reconciled with the Supreme Court cases that purportedly gave birth to that doctrine. Part II explains how courts apply economic substance of statutory language. Part III demonstrates that uses economic only to the extent that the applicable statute makes them relevant. Although this distinction may seem subtle at first, Part IV shows that the two approaches are in fact irreconcilable. Part IV also recommends that the Court its prior holdings, and addresses counterarguments report’s conclusions. II. Lower Courts’ Approach Before analyzing the lower courts’ approach, a few disclaimers are required. First, to suggest that courts act suggest that way all of the time. Most courts, most of the time, faithfully apply Congress’s statutes. Without more, the economic substance cases discussed here should be viewed as departures from a pattern, rather than as evidence of one. Nevertheless, because the lower courts the Supreme Court’s approach have injected significant confusion into the tax laws and worth billions dollars, their opinions demand close scrutiny. Second, this report is primarily concerned with how the decisions they have reached. Many have objected to the substantive results that the courts have reached in the economic substance cases. This report is only secondarily concerned with those objections. To that end, the facts in the following cases have been vastly simplified to highlight the courts’ methods of interpretation. There is no shortage of criticism or praise for the courts’ results in the existing literature, and those wondering whether courts have reached the ‘‘right’’ ones should review that literature.9 Third, and most important, this report assumes that the best evidence of legislative intent (alternatively ‘‘legislative purpose’’ or ‘‘legislative will’’) is found in the words that Congress uses in its statutes. This is the dominant view on the Court today,10 but that has not addition to the statutory provisions, the courts have developed several doctrines over the years to deny certain tax motivated transactions their intended tax benefits. These doctrines are not entirely distinguishable, and their application to a given set of facts is often blurred by the courts and the IRS.’’). This report is concerned with cases in which a lower court applies a prerequisite potential and/or business purpose test taxpayer’s transaction. See infra Part II. This test is usually, but not always, referred to as the economic substance doctrine. 6ACM, 157 F.3d at 259 (discussing the ‘‘judicially created economic substance doctrine’’). 7See, e.g., Lerman v. Commissioner, 939 F.2d 44, 52 (3d Cir. 1991). (‘‘Economic substance is a prerequisite to the application of any Code provisions allowing deductions.’’) 8Stauffer’s Estate v. Commissioner, 403 F.2d 611, 621 (9th Cir. 1968). (‘‘Gregory v. Helvering teaches that mere compliance with the Code provisions resulting in a tax advantage will be sanctioned by the courts only when there is, independent of the business or corporate purpose.’’) 9See, e.g., Karen C. Burke, ‘‘Black & Decker in the Fourth Circuit: Tax Shelters and Textualism,’’ Tax Notes, Apr. 17, 2006, p. 6237, 2006 TNT 74-28; Daniel ‘‘It’s Not a Lie if You Believe It: Tax Shelters and the Economic Doctrine,’’ 58 Fla. L. Rev. 665, 711 Yale, ‘‘Reexamining Black & Decker’s Contingent Liability Tax Shelter,’’ Tax Notes, 11, 223, TNT 29; Alexandra M. Note, ‘‘Wrong: Corporate Tax Shelters, Practical Reason and the New Textualism,’’ 53 Rev. David ‘‘and the Tax Shelter,’’ 57 Tax L. Rev. P. Hariton, ‘‘The Compaq Case, Notice 98-5, and Tax Shelters: The All Wrong,’’ Tax Notes, Jan. 2090, 2002 TNT 19-31; David ‘‘Truths About Shelters,’’ 215 (2002); Michael ‘‘More Truths About Tax Shelters: The Problem, Possible Solutions, and a Reply to ProfessorWeisbach,’’ 55 Tax L. Rev. 325, 361 (2002); Daniel N. Shaviro and David A Weisbach, ‘‘The Fifth Circuit Gets it Wrong in Compaq v. Commissioner,’’ Tax Notes, Jan. TNT Bankman, ‘‘The Economic Substance Doctrine,’’ 74 S. Cal. L. Rev. 5 (2000); and David P. Hariton, ‘‘Sorting Out the Tangle of Economic Substance,’’ 52 Tax Lawyer 235 (1999). 10See, e.g., W.Va. Univ. Hosps. v. Casey, (1991) (‘‘The best evidence of congressional purpose is the statutory text adopted by both Houses of Congress and submitted to the President.’’); Connecticut Nat. Bank v. Germain, 503 U.S. 249, 253-254 (1992) (‘‘Canons of construction are no more than rules of thumb that help courts determine the meaning of legislation, and in interpreting a statute a court should always turn first to one, cardinal canon before all others.We have stated time and again that courts must presume that a legislature says in a statute what it means and means in a statute what it says there. When the words of a statute are unambiguous, then, this first canon is also the last: ‘judicial inquiry is complete.’’’); City of Chicago v. Environmental Defense Fund, 511 U.S. 328, 337 (1994) (‘‘It is the statute, and not the Committee Report, which is the expression of the law.’’); Ratzlaf v. United States, 510 U.S. 135, 147-148 (1994) (‘‘There are, we recognize, contrary COMMENTARY /next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT cases raise many difficult pattern, than as and one can understand why the lower wish to get involved. However, the lower that have strayed from the Supreme Court's approach courts' an economic substance con-tradicts precedent, cir-have decided cases worth (in the aggregate) billions of cuit splits, and is inconsistent with well-settled rules of opinions demand close Given that "cre-this report concerned how ated"6 doctrine is a "prerequisite" courts have reached their decisions, rather than the every code provision offering tax benefits,7 the Court should affirm its prior holdings and instruct the lower This report is only tests with those facts While the Court itself applies economic substance (and sometimes even the applicable statutes) in the principles from time to time, it does so only when the cases have been vastly simplified to courts' shortlower courts, contrarily, apply economic substance prin-age courts' the ciples (that is, they apply a free-floating test). Through applying a rule of decision the "right" literathat reference courts ture.9 "mere the code"8 most important, this report assumes to enjoy tax benefits. of legislative intent (alternatively "leg-This report argues that the lower courts' application of islative purpose" or "will") the a free-floating economic substance doctrine cannot be Congress in statutes. the the Supreme that purport-on the Court today,1° has edly that doctrine. explains lower courts apply economic substance principles regardless of the Supreme Court uses economic substance principles 9See, e.g., Karen C. Burke, "Black & in Tax Shelters and Textualism," Tax Notes, 17, 2006, distinction may seem 315, Doc 2006-6237, 2006 TNT 74-28; Daniel J. Glassman, Note, shows that the two approaches "It's Not a Lie if You Believe It: Tax Shelters the Economic that Substance Doctrine," 58 Fla. L. Rev. 665, 711 (2006); Ethan Yale, affirm its prior holdings, and addresses possible counter-"Decker's Tax Shelarguments to this report's conclusions. ter," Tax Notes, July 11, 2005, p. 223, Doc 2005-13102, 2005 TNT 132-29; Alexandra M. Walsh, Note, "Formally Legal, Probably Tax and the Lower Courts' Approach Textualism," 53 Stan. L. Rev. 1541 (2001); David P. Hariton, analyzing the courts' "Kafka and the Tax Shelter," 57 Tax L. Rev. 1 (2003); David P "The Compaq Case, 98-Tax one way some of the time is not to suggest that they act Theory Is All Wrong," Tax Notes, Jan. 28, 2002, p. 501, Doc of the time. Most courts, 2002-2090,2002 TNT 19-31; David Weisbach, "Ten Truths About apply Congress's statutes. Tax Shelters," 55 Tax L. Rev. 215 (2002); Michael L. Schler, "Ten discussed here be About Tax Shelters: The Problem, Possible a Reply to Professor Weisbach," 55 Tax L. Rev. 325, 361 Daniel N. and Weisbach, "Gets it Wrong in Compaq v. Commissioner," Tax Notes, Jan. 28, 2002, p. 511, Doc 2002-2091, 2002 TNT 19-31; Joseph Bankaddition to the statutory provisions, the courts have man, "The Economic Substance Doctrine," 74 S. Cal. L. Rev. over to and David Hariton, "the Tangle tax benefits. These Substance," 52 Tax Lawyer 235 (1999). 10See, e.g., WVa. Univ. Hasps. Inc. v. Casey, 499 U.S. 83, 98-99 IRS."). ("best evidence congressional with in which applies a prereq-by both Houses submituisite profit potential and/or business purpose test to a taxpay-ted President."); Connecticut Nat. Bank v. Germain, 503 S. er's infra Part II. This 254 (1992) ("Canons of construction are no as economic substance thumb that help courts determine the meaning 6ACM, 3d at discussing the "created a statute doctrine"). first to one, cardinal canon before all others. We 7See, e.g., Lerman v. presume that a legislature says ("to the application means says deductions.") 8Staufer's 403 F.2d 621 (9th the last: 'judicial complete."'); ("v. Helvering teaches that mere compliance with Defense resulting in tax advantage will be ("is the statute, the authoritative expression of the law."); Ratzlaf v. United States, 510 tax consequences, business or corporate purpose.") ("recognize, (Footnote continued on next page.) 970 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315always been the case.11 Further, eminent scholars (and justices) have capably argued for different conceptions of Many in not consider statutory language the best evidence of legislative intent. Tax scholars have long favored a strong under which an ‘‘underlying’’ legislative the code so as to improve the structure or integrity of the tax system.Nonetheless, to borrow Judge Easterbrook’s words, ‘‘I appreciate the temptation to make every law ‘the best it can be,’ but that is not the Supreme Court’s current mode of statutory interpretation.’’14 Because this indications in the statute’s legislative history. But we do not resort to legislative history to cloud a statutory text that is clear.’’); United States 520 U.S. 1, 6 (1997) (‘‘Given straightforward statutory command, there is no reason to resort legislative history.’’); Dunn v. Commodity Futures Trading 519 U.S. 465, 474 (1997) (‘‘We . . . think underlying the Treasury Amendment are most properly fulfilled by giving effect to the plain meaning of the language as Congress enacted it.’’); United States v. LaBonte, 520 U.S. 751, 757 (1997) (‘‘In determining whether [the agency’s guideline] accurately reflects Congress’ intent, we turn, as we must, to the statutory language.’’); United States v. Lanier, 520 U.S. 259, 267 (1997) (‘‘The legislative intent of Congress is to be derived from the language and structure of the statute itself, if possible, not from the assertions of codifiers directly at odds with clear statutory language.’’); Brogan v. United States, 522 U.S. 398, 408 (1998) (‘‘Courts may not create their own limitations on legislation, no matter how alluring the policy arguments for doing so, and no matter how widely the blame may be spread. Because the plain language of [the statute] admits of no exception . . . we affirm the judgment of the Court of Appeals.’’); Pennsylvania 524 U.S. 206, 212 (1998) (‘‘The that a statute can be ‘applied in situations not expressly anticipated not ambiguity. demonstrates breadth.’’’) (unanimous); Carter v. United States, 530 U.S. 255, 270-271 (2000) (‘‘Legislative history is unavailing in light of this Court’s approach to statutory interpretation, which begins by examining the text, not by psychoanalyzing those who enacted it.’’); Hartford Underwriters Ins. Co. v. Union Planters N.A., U.S. 1, 6 (2000) (‘‘When the statute’s plain, the sole function of the courts — at least where the disposition required by the text is not absurd — is to enforce it according to its terms.’’); Alexander v. Sandoval, 532 U.S. 275, 288 (2001) (‘‘We . . . begin (and find that we can end) our search for Congress’s intent with the text and structure of Title VI.’’); Gitlitz 2001 TNT (2001) (‘‘Because the Code’s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern.’’); Chickasaw Nation v. United States, 534 U.S. 84, 85 (2001) (canons ‘‘are designed to help judges determine the Legislature’s intent as embodied in particular statutory language’’); Barnhart v. Sigmon Coal Co., Inc., 534 U.S. 438, (‘‘Floor statements from two Senators cannot amend the clear and unambiguous language of a statute. We see no reason to give greater weight to the views of two Senators than to the collective votes of both Houses, which are memorialized in the unambiguous statutory text.’’); Barnhart v. Thomas, 540 U.S. 20, 26 (2003) (‘‘When a statute speaks clearly to the issue at hand we ‘must give effect to the unambiguously expressed intent of Congress’.’’) (unanimous); Engine Manufacturers Association v. Air Quality Management 541 S. (2004) (‘‘Statutory construction must begin with the language employed by Congress and the assumption that the ordinary meaning of that language accurately expresses the legislative purpose.’’); Lamie v. United States Trustee, 540 U.S. 526, (‘‘If Congress enacted into law something different from what it intended, then it should amend the statute to conform it to its intent. . . . In the meantime, we must determine intent from the us.’’); Exxon Mobil Corp. v. Allapattah Services, Sup. Ct. 2611, 2626 (2005) (‘‘As we have repeatedly authoritative statement is the statutory text, not the legislative history or any other extrinsic material.’’); Dodd v. United States, 353, 359 (2005) (‘‘Although we the for harsh results in some cases, we are not free to rewrite the statute that Congress has enacted.’’); Powerex Corp. v. Reliance Energy Services, 551 U.S. — (2007) (Policy debates belong ‘‘in the halls of Congress, not in the hearing room of this Court. As far as the Third Branch is concerned, what the text of [a statute] indisputably does prevails over what it ought to have done.’’); Ledbetter v. Goodyear Tire & Rubber Co., Inc., 127 Sup. Ct. 2162, 2177 (2007) (‘‘We are not in a position to evaluate Ledbetter’s arguments. . . . written.’’). Although the foregoing cases do not reflect the approach taken in every Court opinion during the past 15 years, the Court almost always resolves disputes by analyzing statutory language, although Justices continue to debate which extrinsic aids may be consulted in determining the meaning of that language. The has gone as Church States, 143 U.S. 457 (1892), the seminal case for applying a statute’s ‘‘spirit’’ rather than its words, since 1989. See Public United States Dept. of Justice, S. 11See, e.g., Bob Jones University v. United States, 461 U.S. 574, 586 (1983). (‘‘It is a well-established canon of statutory construction that a court should go beyond the literal language of a statute if reliance on that language would defeat the plain purpose of the statute.’’) See also Beverly I. Moran and Daniel M. Schneider, ‘‘The Elephant and the Four Blind Men: The Burger Court and Its Federal Tax Decisions,’’ 39 How. L. J. 841, 928 (1996) (discussing six ‘‘Burger Court opinions that fashioned tax law without the assistance of statutory language, regulatory guidance or legislative history’’). 12See, e.g., William N. Eskridge Jr., ‘‘Dynamic Statutory Interpretation,’’ Pa. L. Rev. Aleinikoff, ‘‘Updating Statutory Interpretation,’’ 87 Mich. L. Rev. William and Philip P. Frickey, ‘‘Statutory Interpretation as Practical Reasoning,’’ 42 Stan. L. Rev. 321 (1990); David P. Hariton, ‘‘Tax Benefits, Tax Administration, and Intent,’’ Breyer, Active Liberty: Interpreting Our Democratic Constitution 13See, e.g., Deborah A. Geier, ‘‘Interpreting Tax Legislation: The Role of Purpose,’’ 2 Fla. Tax Rev. 492 (1995); Lawrence Zelenak, ‘‘Thinking About Nonliteral Interpretations of the Revenue Code,’’ 64 N.C. L. Rev. criticism of the antitextual approach, see John F. Coverdale, ‘‘Text as Limit: A Plea for Decent Respect of the Tax Code,’’ 71 Rev. 14Humphries v. CBOCS West, Inc., __ 3d __, 2007 WL 60876 (7th Cir., 2007) (Easterbrook, J., dissenting). See also Steven A. Dean and Lawrence A. Solan, ‘‘Tax Shelters and the Code: Navigating Between Text and Intent,’’ 26 Va. Tax. Rev. __ 2007). (‘‘aggressive the interpretation of the tax laws regardless of the statutory language is too far outside today’s jurisprudence to be a credible option.’’) COMMENTARY /continued (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT always been the case.11 Further, eminent scholars (and capably argued for legislative intent.12 Many tax scholars, in particular, do consider language best evidence statute's But Tax history to purposive approach, under which an "underlying" legclear."); United States v. Gonzalez, 520 U.S. 1, 6 (1997) ("Given the islative intent may require antitextual interpretations of statutory command, there is no reason as to improve the structure or integrity to legislative history"); Dunn v. Commodity Futures Trading Commission, 519 U.S. 465, 474 (1997) ("We ... think the purposes 13 Nonetheless, to borrow Easterbrook's the Amendment most properly fulfilled "I appreciate giving effect to the plain meaning of the language as 'be,' is not the Supreme Court's it."); United States v. LaBonte, 520 U.S. statutory interpretation."14 Because ("In [the agency's accurately Congress' intent, we turn, language."); United States v. Lanier, 520 U.S. 259, 267 ("legislative is to be derived from possible, assertions of directly clear Services, 551 U.S. -(2007) (Policy debates belong "language."); Brogan v. United States, 522 U.S. 398, not in room ("Courts may their own legisla-what [a statute] tion, the arguments so, to have done."); widely the blame may be spread. Because v. Tire & Co., Inc., 2162, statute] admits of no exception ... (2007) ("We are not in evaluate Ledbetter's the judgment of the Court of Appeals."); Pennsylvania policy arguments... We apply the statute as written."). Al-Dept. of Corrections v. Yeskey, 524 U.S. 206, 212 (1998) ("The fact though cases do 'expressly antici-Court opinion the past 15 pated by Congress does not demonstrate ambiguity. It demon-language, alstrates breadth."') (unanimous); Carter v. United States, 530 U.S. though continue which 270-271 (2000) ("Legislative history is unavailing in light meaning that language. The Court's begins Court has not gone so far as to cite Holy Trinity Church v. United examining text, not by psychoanalyzing those the seminal case for it."); Hartford Underwriters Ins. Co. v. Union Planters statute's "spirit" rather than its words, since 1989. See Public Bank, N.A., 530 U.S. 1, 6 (2000) ("When the statute's language is Citizen v. United States Dept. of Justice, 491 U.S. 440, 453-454 function of -at least where the (1989). text is not absurd -is to enforce 11 See, e.g., Bob Jones University v. United to its terms."); Alexander v. Sandoval, 532 U.S. 275, (1983). ("It is a well-of statutory construc-("We ... that we can search tion a court should go beyond the literal language a Congress's intent with structure of Title VI."); GitlitL reliance language v. Commissioner, 531 U.S. 206, 220, Doc 2001-1085, 2001 TNT 7-13 statute.") See Beverly I. Moran ("the Code's plain the taxpayers "Elephant and benefits, we need not this and Its Federal Tax Decisions," 39 How. L. J. concern."); Chickasaw United States, 534 (discussing six "Burger Court "to judges determine the without the assistance statutory language, regulatory Legislature's intent in lan-history"). guage"); Barnhart v. Sigmon Coal Co., Inc., 534 U.S. 438, 457 (2002) 12See, e.g., William N. "Dynamic Statutory ("statements two Senators Interpretation," 135 U. Pa. L. Rev. 1479 (1987); T. Alexander a statute. We see "Updating Statutory Interpretation," 87 Mich. L. Rev. two Senators 20 (1988); William N. Eskridge Jr. and Philip P Frickev, "Statucollective which tory Interpretation as Practical Reasoning," 42 Stan. L. Rev. 321 statutory text."); Barnhart v. Thomas, 540 U.S. 20, David Hariton, "Tax Administration, ("clearly hand Legislative Intent," 53 Tax Law. 579, 613-614 (2000); Stephen 'effect to the unambiguously expressed Breuer, Our Democratic Constitution Congress'.") Engine Manufacturers Association v. 85-101 (2005). South Coast Air Quality Management Dist., 541 U.S. 246, 252 13See, e.g., Deborah A. Geier, "Interpreting ("the language Purpose," 2 Fla. Tax Rev. and that "Nonliteral Interpretations the that language accurately expresses Internal Revenue Code," 64 N.C. L. Rev. 623 (1986). For a purpose."); Lamie v. United States Trustee, 540 U.S. 526, 542 (2004) of the antitextual approach, see John F. Coverdale, ("Congress into law something different from "A Plea for Decent Respect the Tax Code," 71 to conform it Tul. L. Rev. 1501 (1997). intent... 14Humphries v. CBOCS West, Inc., -F.3d -, 2007 WL 60876 statute before us."); Exxon Mobil Corp. v. Allapattah Services, Inc., 2007) See 125 Sup. Ct. 2611, 2626 (2005) ("As we have repeatedly held, the Lawrence Solan, "Tax Shelters the Code: Intent," Tax. Rev. or any other extrinsic material."); Dodd v. United States, (forthcoming 2007). ("An aggressive purposive approach to th-e 545 U.S. 353, 359 (2005) ("Although we recognize the potential tax laws regardless lanfor some we are not free to guage today's be Congress has enacted."); Powerex Corp. v. Reliance option.") (Footnote continued in next column.) TAX NOTES, September 10, 2007 971 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315courts’ inconsistent with the Supreme Court’s, it is the high court’s statute-based approach that guides the analysis below.15 A. Coltec v. United States In Coltec Industries, Inc. v. United States,16 the Court of Appeals for the Federal Circuit invoked the economic doctrine taxpayer’s with the code. In that case, the taxpayer (Coltec) engaged in a multistep transaction that created valuable tax benefits. Coltec turned a dormant subsidiary (Garrison) into a purpose entity a promissory note with a face amount of $375 million.17 In exchange for that promissory note, Garrison agreed to assume contingent asbestos liabilities in the amount of $374.5 million.Coltec then sold its stock in Garrison for $500,000, claiming a large loss on the sale.19 Sections 351 and 358 governed the tax treatment of Coltec’s transaction.Section 351(a) provides that when property is transferred to a controlled corporation in for stock in or loss is immediately recognized. Section 358(a) provides rules determining the basis of the stock that the shareholder receives in exchange for the property transferred. That section says that the basis of stock received in a transfer is the as that of the property decreased by the amount of money received by the shareholder.Although the assumption is ordinarily treated as money received the transferor,22 section 358(d)(2) states that liabilities that ‘‘give rise to a deduction’’ will not be treated that way.23 The Federal Circuit completed a thorough analysis of the applicable statutes. The court first found that Coltec’s basis in the note transferred to Garrison was equal to its 24 examined whether the assumed liabilities would give rise to a deduction such that Coltec could exclude them when determining its basis in the Garrison stock.25 The government argued that Coltec could not, but after a careful parsing of various interrelated statutes, the Federal Circuit found in favor of Coltec on that point.26 the liabilities reduce Coltec’s its Garrison stock, the stock’s basis was $375 million. However, Garrison as a whole was worth much less — million of asbestos liabilities. Thus, Coltec’s basis in the Garrison stock excess of disposition of the stock for $500,000, Coltec claimed a large loss. The court concluded that the code in fact allowed Coltec to recognize that loss.27 Although the court could ‘‘find nothing in the literal terms of the statute’’ that disallowed Coltec’s claimed benefits,its analysis did not stop with the language of the code. Instead, the court proceeded to apply the general economic substance doctrine.Under its interpretation of the doctrine, ‘‘transactions that comply with the literal terms of the tax Code but lack economic reality’’ must be disregarded.30 The court stated that various Supreme Court precedents affirmed the legitimacy of the doctrine and that the doctrine represents ‘‘a judicial effort to enforce the statutory purpose of the tax Code.’’The court also stated that the ‘‘economic substance doctrine a prerequisite to the application Code provision allowing deductions.’’32 According to the court, the doctrine applies whenever a taxpayer’s sole is tax avoidance33 lacks economic reality.34 transfer of the promissory note, because ‘‘the transaction to be analyzed is the one that gave rise to the alleged tax benefit.’’35 The court concluded that the transaction 15Although academics continue to debate which extrinsic one may properly of statutory language, ‘‘all statutory interpretation theorists agree that judges must look to the words of the statute in order to resolve legal controversies.’’ Nancy Staudt, ‘‘Judging Statutes: Regimes,’’ 38 Loy. L.A. L. Rev. 1909, 1970 n.95 (2005). (citing William N. Eskridge Jr., ‘‘Textualism, the Unknown Ideal?’’ 96 1509, 1557 (1998). (‘‘All major consider plain meaning of a text, as applied to a set of facts, is the focal point for attention whether one is a textualist, intentionalist, or of statutes.’’)) That general consensus notwithstanding, some tax scholars continue to question the authoritative weight of congressionally enacted statutes. This unusual approach is seen in some lower court cases, see infra, but is at odds with statutory interpretation theory generally. See Michael Livingston, ‘‘Practical Reason, ‘Purposivism’ and the of Tax Statutes,’’ 51 Tax L. Rev. 677, 710-712 (1996). (‘‘The tax debate seems strangely uninformed by broader interpretation scholarship, which regards purpose as a rather oldfashioned concept.’’) 16454 3d 13276, 2006 TNT id. 18See 19See id. 20Section references in this report are to the provisions of the Internal Revenue Code of 1986 (or predecessor enactments) as in effect during the tax years at issue. 21Section 358(a)(1). 22Section 23Section 358(d)(2) operates via a cross-reference to section 357(c)(24See id. at 25See id. 26See id. 27See id. at 1351. (‘‘The consequence is that under the literal terms of the statute the basis of Garlock’s Garrison stock is increased by the [promissory] note and is not reduced by the assumed contingent asbestos liabilities. Ultimately, the taxpayer would not be disqualified from claiming the capital loss.’’) 28Id. 30Id. 31Id. 32Id. at 1356 (quotations and citations omitted). 33Id. 34Id. 35Id. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT report argues that the lower courts' approach is inconsis-the transferor,22 section 358(d)(2) states that liabilities tent the Supreme Court's, it the high court's t"hgaivte rise a deduction" will not be treated that way.23 statute-based approach that guides the analysis below.15 Circuit The court first Coltec's Coltec v. States Coltec 16 the Court face amount ($375 million).24 The court then examined the Federal invoked the economic liabilities would give substance doctrine to disregard a taxpayer's compliance exclude the code. In that case, its basis in the Garrison stock.25 governin transaction that created ben-ment could not, but afer a careful efits. turned interrelated statutes, Cira special purpose entity and then transferred to Garrison cuit in favor of Coltec on that point 26 a face amount of $375 million.17 Because the liabilities did not reduce Coltec's basis in for Garrison stock, the stock's basis was contingent asbestos liabilities in the Garrison as a whole was worth much less -million.18 Coltec then sold its stock in Garrison the company had assumed $374.5 million worth of asbes$claiming loss on the sale.19 tos Thus, Coltec's Garrison stock was well in excess of its fair market value and on the 351 and 358 governed the tax the stock for $500,000, Coltec's 20 Section 351(a) provides that that fact transferred controlled allowed Coltec to recognize that loss.27 exchange for stock in that corporation, generally no gain "loss is immediately recognized. Section 358(pro-the statute" that disallowed Coltec's claimed vides 28 its analysis did not stop with in for the property trans-code. to the ferred. doctrine.29 Under its intera section 351 transfer is the same as that of the property pretation "that comply with exchanged, decreased by the amount of any money terms of the tax Code but lack economic 21 Although reality" must be disregarded 30 stated of liabilities is ordinarily treated as money received by affirmed represents "effort to enforce Code."31 The court also stated that "economic doctrine is a prerequisite to the application of any deductions."32 15Although academics extrinsic doctrine applies whenever a taxpayer's sole sources one may properly consult in determining the meaning subjective motivation is tax avoidance33 or if a transaction statutory language, "statutory interpretation theorists reality.34 that judges must look The court then applied the doctrine to only the transto controversies." "Judging Statutes: fer note, because "Interpretive Regimes," 38 Loy. L.A. L. Rev. 1909, 1970 n.95 (2005). is the alleged N. Eskridge Jr., "Textualism, Unknown benefit."35 concluded the transaction Ideal?" 96 Mich. L. Rev. 1509, 1557 (1998). ("All major theories of statutory interpretation consider the statutory text primary. The meaning a text, as to a set facts, attention whether one pragmatic interpreter of statutes.")) That general consensus 22Section 358(d)(1). 23Section d)(cross-weight of congressionally enacted statutes. 3577c)(3). approach is seen in some lower court cases, see 4See id. at 1344 n.2. statutory interpretation theory generally. See 25See id. at 1349. "Practical Reason, 'Purposivism' 26See id. Interpretation of Tax Statutes," 51 Tax L. Rev. 677, 710-712 (1996). 27See id. ("is that under the ("strangely uninformed inter-the statute the basis Garlock's Garrison pretation old-by the [fashioned concept.") liabilities. Ultimately, 16454 F.3d 1340, Doc 2006-13276, 2006 TNT 134-10 (Fed. Cir. not be from claiming the capital loss.") 2006). 28Id. at 1347. 17See id. at 1344. 29Id. at 1351. 18See id. 30Id. at 1352. id. at 1345. 31Id. at 1353-1354. 20Section references in this report are to the provisions 32Id. (quotations and Revenue Code of 1986 33Id. at 1356. the tax years at issue. at 1352. 21Section 35Id. at 1356. 972 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315lacked economic substance because it did not ‘‘appreciably affect’’ Coltec’s beneficial interests and did not provide ‘‘real ‘opportunity make profit.’’’36 Because that transaction was disregarded, Coltec’s basis in its Garrison stock could not be inflated by note,37 loss to recognize on the sale of the Garrison stock. The court thus entered judgment in favor of the government. The Federal Circuit’s application of the economic substance doctrine to only the transfer of the promissory note (as opposed to the whole transaction) has caused some controversy.38 That controversy is not relevant here. Rather, it is sufficient to observe that the court did not point that implicitly explicitly indicated that economic substance be applied. The Federal Circuit did not even deny that Coltec’s was exactly what it purported be,39 but instead concluded that it was empowered to go ‘‘beyond the literal language of a statute.’’40 Although the Federal Circuit performed a detailed analysis of the statutory scheme before applying the economic substance doctrine,much of its analysis was conclude the applicable statutes, conclusion did not bear on the ultimate disposition of the case. Indeed, at least one circuit court has concluded that statutory analysis is not at all required in economic substance cases. re In re CM Holdings,42 the Third Circuit addressed whether the taxpayer (Camelot) could enjoy interest deductions with respect to its corporate-owned life insurance policies.43 In a highly leveraged transaction, Camelot insurance policies on account of 1,430 employees. attributable purchase resulted in purportedly tax-deductible interest payments. The IRS, however, argued that those deductions the applicable statutes the economic substance doctrine. began ‘‘relatively simple’’ statutes that would seemingly govern the controversy.44 The court observed that section 163(a) allows a deduction for ‘‘all interest paid or accrued within the taxable year on indebtedness,’’ but section 264(a)(3) limits that deduction when the underlying indebtedness is attributable to the leveraged purchase of life insurance contracts. Camelot argued that the section 3) was inapplicable because company qualified for a special safe harbor exception found in section 264(d). The Third Circuit did not consider Congress’s statutes relevant, however. Rather, the court stated: We can forgo examining the intersection of these details, for pursuant to Gregory v. Helvering Knetsch courts have beyond taxpayers’ formal compliance with the substance to the application of any Code provision allowing deductions. It is the Government’s trump card; even if a transaction complies precisely with all requirements for obtaining a deduction, if it lacks economic substance it ‘‘simply is not recognized for federal taxation purposes, for better or for worse.’’45 After concluding that statutory analysis was unnecessary, the court examined two aspects of the COLI transaction ‘‘to determine if it ha[d] economic substance: its objective economic substance and the subjective business motivation behind it.’’46 The court discovered a ‘‘damning piece of evidence’’ that indicated that the COLI transaction could not pass the judicial tests and consequently denied the taxpayer the claimed interest deductions.47 The court then examined whether the imposition of related penalties Camelot of sections 264 to a COLI transaction raised issues of first impression, penalites should not apply. The court rejected Camelot’s arguments, however, emphasizing that it had not interpreted any statutes in reaching its holding: Only one case has broadened the common law exception for cases of first impression, which prevents the imposition of penalties, to the field of accuracy-related penalties for substantial understatement. But even this exception is reserved for issues where the statutory language was unclear. As the District Court pointed out, in this case there unclear only ‘‘36Id. 37Id. 38See Gregory N. ‘‘Don’t Make Coltec Problem Worse,’’ Legal Times, Mar. 26, 2007. 39See also John F. Prusiecki, ‘‘Coltec: A Case of Misdirected Analysis of Economic Substance,’’ Tax Notes, Aug. 7, 2006, p. 2006-13972, 2006 TNT 152-83. (‘‘The court . . . did recharacterize any part of the transaction as being other than what it purported to be. Rather the court said that the note/liability transfers were motivated solely by tax concerns, had no meaningful nontax economic purpose, and therefore lacked economic substance.’’) 40454 1354. 41See id. 42301 F.3d 96, Doc 2002-19191, 2002 TNT 161-10 (3d 43Camelot purchased those policies after being approached by a third-party promoter (Newport Inc.) that designed highly leveraged COLI plans. See id. at 100. 44Id. 45Id. at 102 (citations omitted). 47See id. at 102-103. (‘‘Camelot’s COLI plan lacked economic substance. It fails the objective prong because, outside of tax considerations, the transaction had no net economic effect on Camelot’s financial position. It fails the subjective prong because at the time the plan was under consideration and agreed on, all parties focused solely on the tax benefits the plan provided. Ultimately the most damning piece of evidence against Camelot is that the marketing information presented to its executives showed that, absent tax deductions, the plan lose to the plan knowing deductions were the only thing that made it worthwhile.’’) COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT because it did not "apprecia-"all interest paid or accrued bly affect" Coltec's and did pro-the taxable year on indebtedness," but section vide Coltec with any "real 'opportunity to make a 3) limits deduction the underlying profit."'36 that transaction Col-tec's in its Garrison stock could not be infated insurance the promissory note,37 and Coltec consequently had no 264(a)(3) limitation was inapplicable because the comloss stock. pany for a special safe section 264(Circuit's the economic did not consider Congress's statutes doctrine to only stated: whole transaction) has caused some controversy.38 That controversy is not relevant here. intersection these it that the court statutory details, for pursuant to Gregory v. Helverpoint to any statutory language that implicitly or explic-ing and Knetsch v. United States, courts have looked itly indicated that economic substance principles should taxpayers' with the Circuit Code and analyzed the fundamental substance of Coltec's transaction was exactly what it was purported to transactions. Economic substance is a prerequisite be 9 but concluded "be, yond the literal language of a statute."40 It the Government's card; Federal performed a detailed a transaction with statutory scheme the for lacks 41 much of it "ultimately irrelevant. While the court did conclude that worse."45 Coltec had complied with the applicable statutes, that concluding that statutory analysis was unnecesconclusion ultimate sary, of transcase. Indeed, at least one circuit court concluded action "determine if it ha[d] economic substance: is all required in economic cases. behind it."46 "damn-B. In re CM Holdings ing piece evidence" indicated COLI In In re CM Holding 2the Circuit addressed pass tests and consewhether taxpayer s(enjoy interest quently deducdeductions respect owned insurtions ance policies 43 In a highly leveraged transaction, Cam-47 elot purchased life insurance policies on account of 1,430 accuracy-related penalties was appropriate. Camelot of its employees. The indebtedness attributable to that argued that, because the application of sections 163 and resulted in tax-of imprespayments. deduc-sion, apply. The court rejected tions were unavailable under the applicable statutes and Camelot's emphasizing that The Third Circuit began its analysis by mentioning the one case "simple" statutes seemingly of first pre-the controversy44 The court observed that section 163(a) vents to the related penalties for But 36 language was unclear. 1d. at 1360. 37 pointed out, in this case 1d. 38See Gregory N. Kidder, "Don't Make Coltec Problem is no unclear statutory language, only "applying Worse," Legal Times, 26, 2007. 39See also John F. Prusiecki, "Coltec: A Case of Misdirected Analysis of Economic Substance," Tax Notes, Aug. 7, 2006, p. 524, Doc 2006-13972, 2006 TNT 152-83. ("The court ... did not 451d. (citations any part 46Id. purported to be. Rather 47See id. at 102-103. ("Camelot's COLI plan transfers were motivated solely by tax concerns, It because, economic therefore lacked the economic eco4n0omic substance.") Camelot's fails the subjective be-454 F. 3d at 1354. cause at the time agreed id. at 1340-1351. parties focused tax benefits plan `12301 F.3d 96, Doc 2002-19191, 2002 TNT 161-10 (3d Cir. 2002). the most damning piece of evidence 43Camelot approached is that presented promoter Inc.) executives plans. See at 100. would lose money. Camelot agreed to the plan knowing the tax 441d. at 101. were the only thing that made it worthwhile.") TAX NOTES, September 10, 2007 973 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315novel facts to the judicially created [economic substance] doctrine.’’ Id. at 108 (citations omitted). Because the first impression exception was limited to only those cases in which courts apply statutes, Camelot could not argue that that exception was available — the Third Circuit expressly declined to examine sections 163 and 264. The court thus found that the accuracy-related applied to the taxpayer. Unlike the Federal Circuit in Coltec, the Third Circuit did not perform a preliminary analysis of the applicable statutes to determine whether the taxpayer’s transaction their terms. Rather, the court assumed statutes that the economic substance doctrine should be applied before a court even considers statutory language. Nonetheless, the Third Circuit’s approach Circuit’s only in a court denies a taxpayer benefits under the economic substance doctrine, it does not matter whether the court either case, judicially created doctrine operates independently to language. has even concluded when analyzing a taxpayer’s transaction, Congress’s statutes do not even merit citation. C. Compaq v. Commissioner Compaq and Subsidiaries Commissioner,48 the Tax Court addressed whether the taxpayer could enjoy foreign tax credits resulting from a dividendstripping transaction. purchased million worth of American Depository Receipts (ADRs) in ‘‘dividend,’’ meaning that its purchase entitled it to $22 million in dividends that had been declared with respect to those ADRs. One day after the purchase, however, Compaq sold the ADRs ‘‘ex dividend,’’ meaning that Compaq (and not the subsequent purchaser) retained the right to the dividends. The purchase of the ADRs for $890 million and their subsequent sale for $870 million created a $20 million loss. But the $22 million dividend payment more $2 million profit from the transaction. Compaq nonetheless claimed a loss on its return. While the company did receive a $22 million dividend payment from Royal Dutch, the code grants corporations a deduction for dividends received,49 so that payment did not affect Compaq’s federal tax liability. Compaq thus claimed a $20 million tax loss on account of the sale of the ADRs, which it used to offset gain that it had realized in an unrelated transaction. Because foreign taxes were withheld on Royal Dutch’s $22 million dividend payment, Compaq also claimed foreign tax credits transaction. of those at issue in Compaq. The commissioner argued that Compaq was ineligible for the claimed credits. Although the taxpayer’s dividend-stripping transaction implicated numerous provisions,the commissioner did argue had failed statute. Rather, he argued that Compaq was not entitled to the foreign tax credits because the company’s ‘‘transaction had no objective economic consequences or business purpose other than reduction of taxes.’’51 Compaq ‘‘it statutes and regulations,’’it was entitled to the credits. The Tax Court found in favor of the commissioner. Although Compaq had complied with the statutes, the court rejected the taxpayer’s argument that those statutes ‘‘completely set forth Congress’ intent’’ and instead found that an additional economic substance requirement applied.The court concluded that Compaq ‘‘was motivated by the expected tax benefits of the ADR transaction and no other business purpose existed,’’54 and consequently denied Compaq the claimed credits. Although the Tax Court did not cite a single statute in Compaq’s it did the code.Section 6662(a) and (b)(1) provide if a taxpayer negligently disregards the code’s rules or regulations, it will be subject to a 20 percent penalty on its underpayment of tax. The commissioner did not argue that Compaq had disregarded those rules or regulations, but instead stated that the accuracy-related penalty should be imposed because Compaq had ‘‘negligently transaction.’’57 the commissioner found that the application of the penalty was appropriate.58 Compaq demonstrates that the economic substance doctrine will be applied even when the government does support of its position.59 opinion also indicates that the doctrine contradicts even penal provisions. Although the court acknowledged that the code’s regulations, it applied the section 6662 penalty regardless.60 48113 C. 1999), rev’d, 184, 2002 TNT 2001). 49See section 243. 50113 51Id. 52Id. 53Id. 54Id. 55Statutes relevant to a dividend-stripping transaction—but not even cited by the Tax Court — include sections 162-165, also IES 1999 WL973538, Doc 1999-32487, 1999 TNT Iowa 1999), rev’d, 253 F.3d 350, Doc 2001-TNT 116-12 (8th Cir. 2001) (addressing shelter similar to Compaq’s and failing to cite any statutes in holding against the taxpayer). 56In addition to citing section 6662, the court cited section 901(k). Congress enacted that subsection in 1997 to deal with dividend-stripping transactions. Compaq argued that this implied that its transaction was permissible under the law in 1992. The court, however, rejected that argument. See 113 T.C. at 225. 57Id. 226 58See id. at 59See also 277 F.3d at 781. (‘‘The Government has stipulated that aside from its contention that the Royal Dutch transaction lacked economic substance, it has no objection to how Compaq chose to report its tax benefits and liabilities concerning the transaction.’’) 60See also In re CM Holdings, supra Part II.B. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT created economic sub-statutory provisions 50 the commissioner did not argue stance] doctrine." that Compaq had failed to comply with any particular he argued that the first was limited tax credits because company's "transonly in which statutes, action no objective economic consequences busicould was available -ness reduction of taxes."51 Circuit expressly declined to examine sections 163 countered that "because it complied with the applicable court that the accuracy-regulations,"52 it penalty properly applied to the taxpayer. favor of the commissioner. Coltec, the Third Compaq the statutes, the perform a preliminary analysis of the applicable taxpayer's those taxpayer's "Congress' intent" and instead fell within their terms. Rather, the court assumed that the that an additional economic substance requirestatutes were irrelevant and that the economic substance ment 53 The court concluded that "be before a even expected of the Third Circuit's aptransaction and no other business purpose existed,"54 proach differs from the Federal Circuit's only in form. If denies taxpayer benefits the economic the Tax not cite a doctrine, it not matter analyzing Compaq's transaction,55 it did not completely examines the applicable statutes or not. In either case, the ignore the code.56 Section 6662(a) and (b)(1) provide that created doctrine operates a taxpayer negligently disregards code's override statutory language. One court has even con-will be subject to a cluded that, when analyzing a taxpayer's transaction, argue Congress's statutes do not merit instead stated that the accuracy-related penalty imposed because Compaq had "In Compaq Computer Corp. and Subsidiaries v. Commis-disregarded the economic substance of the ADR transacsioner,48 the Tax Court addressed whether tion."57 The court agreed with the commissioner and resulting from dividend-appropristripping transaction. Compaq had purchased $890 mil-ate.58 lion of American Depository Receipts demonstrates that economic substance the Royal Dutch Company "cum dividend," meaning be applied even when the does entitled it million not cite a single statute in support of its position.59 The respect those also contradicts for $870 million "ex dividend," meaning that Compaq Compaq had complied with the code's rules and regula-retained the right tions, it applied the section 6662 penalty ADRs million regardless.60 subsequent created a $20 loss. million than offset the loss from the sale, and Compaq enjoyed a 50113 T.C. at 220. from the transaction. 51Id. claimed a loss on return. 52Id. 22 million 531d. at 225. the 54Id. (punctuation omitted). for dividends received 49 55Statutes relevant to a dividend-stripping transaction -not affect Compaq's federal liability. Compaq the Tax -include sections 162-165, tax loss on account the sale 243-246, 901(a), 904, 1001, and 1211. See also IES Industries v. Commissioner, 1999 WL 973538, Doc 1999-32487,1999 TNT 196-60 used had (N.D. Iowa 1999), rev'd, 253 F.3d 350, Doc 2001-16769, 2001 TNT an unrelated transaction. Because foreign (addressing shelter similar Compaq's were withheld Dutch's $22 million divi-to cite any against the taxpayer). dend 56In to citing section 6662, cited section on account of its transaction. The availability of those enacted that subsection in 1997 to deal with credits was at issue in Compaq. transactions. that im-ineligible plied that its transaction was the law in 1992. the claimed credits. Although the taxpayer's 57 however, rejected that argument. See 113 T.C. at 225. Id. at 226 stripping transaction implicated numerous id. at 227. 59See also 277 F.3d at 781. ("The Government has stipulated it has no objection to how 48113 T.C. 214, 215, Doc 1999-30659, 1999 TNT 183-7 (1999), to tax benefits liabilities concerning rev'd, 277 F.3d 778, Doc 2002-184, 2002 TNT 1-5 (5th Cir. 2001). transaction.") 49See section 60See also In re CM B. 974 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315The Tax Court was eventually reversed by the Fifth Circuit. However, the appellate court did not reject the Tax Court’s invocation of the economic substance doctrine, but only its method of applying that doctrine to the taxpayer’s The court found million profit Compaq enjoyed from the dividend-stripping transaction indicated that it had economic substance.61 Nonetheless, the Fifth Circuit’s opinion is devoid of any analysis, government stipulated that Compaq had complied with the code,the court tested the taxpayer’s transaction against a free-floating doctrine regardless. United States v. Wexler Although the Tax Court found that a violation of the economic doctrine could justify application of a civil penalty, the Third Circuit in United States v. Wexler found that a failure to comply with that doctrine could justify a taxpayer’s criminal conviction.63 The defendant that case allegedly conspiracy to defraud the United States government. hundreds of millions of dollars in fraudulent tax deductions through the use of so-called repo-to-maturity transactions. Those transactions created purportedly deductible interest payments under section 163(a), which provides that ‘‘there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.’’ Before the commencement of Wexler’s criminal trial, the government proposed jury instructions based on the two prongs of the economic substance doctrine, as applied in the Third Circuit. The proposed instructions provided that, if the jury found beyond a reasonable doubt that Wexler had no business purpose for entering into the repo-to-maturity transactions and that Wexler could earn no profit from those transactions apart from tax benefits, the jury must find that the transactions were shams.64 Wexler did not object to those instructions, but requested that, because section interest deductions on account of indebtedness, the judge should make clear that the jury could not convict him if his interest deductions were in fact taken on account of genuine indebtedness. The district judge adopted portions of both parties’ proposed instructions. The judge’s instructions contained the two-part economic substance test offered by the government but further stated that, even if Wexler’s transaction did not comply with the economic substance doctrine, the jury could ‘‘convict the defendant on the count you are considering only if you find that the interest expenses at issue were not the product of a ‘genuine indebtedness.’’’65 The instructions also provided that ‘‘genuine indebtedness exists if the parties and enforce a binding obligation’’ that the ‘‘government must prove the lack of genuine indebtedness beyond a reasonable doubt.’’66 In determining whether the repo-to-maturity transaction created the jurors heed meaningless labels, but would instead be instructed that they ‘‘substance intended by the parties, not only the form that the transaction took.’’67 BeforeWexler’s trial began, the government petitioned the Third Circuit for a writ of mandamus. It contended ‘‘error’’ that his ruling regarding the jury instructions ‘‘would make tax cases involving sham transactions far more difficult to prosecute.’’68 The government argued that a transaction that does not comply with the economic substance doctrine cannot generate lawful interest deductions, even if it ‘‘involve[s] the payment of interest on ‘genuine indebtedness.’’’69 Wexler countered that the district judge’s instructions reflected an accurate statement of law and that the economic substance doctrine should not apply when a taxpayer’s obligation to and enforceable. He argued that ‘‘in contrast to other sections of the Internal Revenue Code allowing for deductions, section 163 not any profit conduct of a trade or business in order to claim the deduction for interest expense.’’70 Whereas deductions and are limited relating of a or business entered into for profit, respectively, the language of section 163 expresses no similar limitations. The Third Circuit agreed that section 163 did not make a taxpayer’s business purpose relevant, but it found that the economic substance doctrine could add requirements beyond those imposed by the statute. The court stated that ‘‘some Code sections expressly require that the deductions they provide for arise from transactions having motive, whereas 163 does not. Nonetheless, the case law construing section 163 establishes [economic substance] doctrine also bars interest deductions under that section of the Code.’’71 That case law demonstrated that ‘‘a key is that [an] interest obligation be economically 61277 787. 62See id. at 781. 6331 3d 1994). 64The word ‘‘sham’’ means different things to different courts. At times, the word sham refers to something that never happened (that is, a factual sham). At other times, sham refers to a transaction that actually occurs but that does not a meet a lower court’s economic substance test (that is, an economic sham). In some opinions, sham is used generally to refer to both factual shams and economic shams. See, e.g., United States v. 140. In sham refers to transaction that does not pass the economic substance test, not to transactions that never occurred. 67Id. 6831 121. 70Id. 71Id. at 122-123 (emphasis supplied). COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT Court reversed by the Fifh comply with the economic substance not reject "convict the defendant Court's of the economic substance doc-only if that the trine, at issue were not the product taxpayer's transaction. The court found that the $2 mil-'indebtedness."'65 prolion Compaq dividend-vided that "genuine indebtedness the parties that it had economic substance.61 intended to create and enforce a binding obligation" and the Fifth Circuit's opinion "government lack of genuine meaningful statutory analysis, and although the govern-doubt."66 In determinment the 62 the court tested the taxpayer's ing whether the repo-to-maturity transaction created genuine indebtedness, the jurors could not heed meana regardless. ingless but would D. United States v. Wexler must consider the "substance of the transaction, as in-tended the transeconomic substance doctrine could justify the application action took."67 civil penalty, the Third Circuit in United States v. Before Wexler's trial the government petitioned found that a failure to comply with a writ of mandamus. It contended a taxpayer's criminal conviction.63 de-that the district judge had made a "clear legal error" and fendant in that case had allegedly participated in a the United States government. regarding instructions "Wexler and his coconspirators allegedly generated hun-cases sham transactions more dreds tax deductions to prosecute."68 the use of so-called repo-transac-that the economic tions. created purportedly doctrine lawful deinterest which ductions, if "s] the payment "there be as interest 'indebtedness."'69 accrued the taxable year on indebted-that judge's ness." an statement of law the of Wexler's criminal substance doctrine should not apply based taxpayer's obligation to pay interest is binding and prongs of the economic substance ap-He argued that "sections plied in the Third Circuit. The proposed instructions Internal Revenue deductions, the jury found beyond a reasonable 163 does not require any profit motive or the Wexler the repo-transactions that Wexler of business in claim the from those transactions for interest expense."70 Whereas jury that the under sections 162 and 212 are limited to those relating to 64 Wexler did not object to those instructions, the carrying on of a trade or business and to transactions because section 163(a) allows interest into profit, respectively, language expresses no similar limitations. clear that the jury him his agreed section were in account taxpayer's purpose relevant, but it found doctrine could both parties' statute. stated judge's "some Code sections two-economic substance test the arise transactions havgovernment but stated even if Wexler's ing a business purpose or profit motive, whereas section law section 163 clearly establishes that the [economic substance] 61 interest deductions 277 F.3d at 787. Code."71 That case law demonstrated that "62 See id. at 781. 63 requirement is that [an] interest obligation be economically 31 F.3d 117 (3d Cir. 1994). 64The "sham" means different sham meet 65Id. court's economic substance test an economic 66Id. opinions, generally 67Id. shams and economic shams. See, e.g., United States v. 6831 F.3d at 121. Atkins, 869 F.2d 135, 139-140. In Wexler, sham refers to a 69Id. at 122. does pass economic substance 701d. 71Id. 123 (emphasis supplied). TAX NOTES, September 10, 2007 975 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315substantive’’ in order to be deducted, meaning that the transaction creating the obligation must have a potential nontax benefit.72 The Third Circuit then announced that its ‘‘rule of disregarding for purposes continues in full with section 163 deductions,’’ emphasizing that ‘‘economic is prerequisite to any Code provision allowing deductions.’’It further found that the Supreme Court’s Knetsch United States ‘‘contradict[ed]’’ Wexler’s arguments.74 It thus set aside the district judge’s instruction relating to genuine indebtedness, finding that his ‘‘instruction would render the [economic substance] doctrine inert’’ and was ‘‘at odds with the overwhelming weight of the relevant case law.’’75 demonstrates that a free-floating economic substance doctrine can apply in criminal cases. That Wexler’s transaction might have created a genuine indebtedness within the meaning of section 163(a) was meet prerequisite judicial test, even though he was facing criminal charges. One court has suggested that the application of the economic substance doctrine in a criminal is repugnant 76 but government to argue that it is criminal trial,77 and the lower courts usually agree.78 E. Summary all lower courts view the economic substance doctrine as a universal, free-floating test. For example, in Horn v. Commissioner,79 the D.C. Circuit parted ways with three circuit courts, the Tax Court, and the commissioner, and concluded that the economic substance doctrine ‘‘cannot trump the plainly expressed intent of the legislature.’’80 The statute at issue in that case (section 108 of Reduction created presumption that commodities dealers, like the taxpayer, business some taxmotivated straddle transactions, any losses suffered by those dealers ‘‘shall be treated as a loss incurred in a trade or business.’’81 The Tax Court nonetheless found that the taxpayer’s lack of business purpose in entering into a straddle disqualified him from enjoying statutory benefits. The D.C. Circuit reversed the Tax Court, stating that its failure to give credence to the statute’s irrebuttable free-floating economic test was ‘‘plainly wrong’’;82 it was ‘‘inconceivable that Congress intended that the [economic substance] doctrine be laid over the statute.’’83 The commissioner had ‘‘close[d] off any consideration of Congress ‘loophole’’’84 the statute and had thereby taken the doctrine ‘‘too far’’85 — his interpretation read the statute ‘‘completely out of existence.’’The court was thus ‘‘to the Commissioner’s suggestion, adopted by several courts, that the independently of section 108.’’87 The court concluded that economic substance principles should be used only 72Id. 73Id. 74Id. at For Knetsch, infra III.B. 75Id. 76See United v. Dahlstrom, 2d 1430 (9th 104 Sup. Ct. 236 (1984). (‘‘These appellants were prosecuted in spite of the fact that no statute, regulation or court decision gave fair warning that advocacy of the creation of lawful foreign trust corporations as a tax shelter would result in a criminal prosecution if the challenged transaction might later be held to lack economic substance for purposes of a civil tax proceeding. Prosecution for advocacy of a tax shelter program in the absence of any evidence of a specific intent to violate the law is offensive to the first and fifth amendments of the United States Constitution.’’) 77See Michael J. Garcia, ‘‘Government Opposes KPMG Defendants’ Motion to Dismiss Indictment,’’ Doc 2006-4307, 2006 44-(Mar. 3, 2006). (‘‘Ingredient Technology and other cases dispose of defendants’ claims . . . that the doctrines of economic substance and substance over form of a criminal case or are vague and unknowable. Ingredient hardly paused in approving the use of these doctrines in a criminal case, and noted that parsing distinctions them was unimportant.’’) 78See, e.g., United States v. Atkins, 869 F.2d 135, 139-140 (2d 1989) (‘‘Appellants’ further contention that the district court’s charge on lack of [economic] substance has no place in a criminal prosecution is without merit.’’); United States v. Manko, F.2d 900, 905 (2d Cir. 1992) (observing that the district ‘‘sided with the government and charged the jury that it could convict if it found either that the transactions did not occur or that they lacked economic substance’’). 79968 F.2d 1229, 1236 (D.1992). 80Id. 81See Tax Reform Act (1986). Section 1808(d) of TRA amended Reduction Act of 1984 (DRA), P.L. 98-369, 98 Stat. 494, 630. Before amendment, section 108 provided a rebuttable presumption that commodities dealers entered into certain straddles with a business purpose. Section 108(b) of the DRA provided, ‘‘Presumption That Transaction Entered Into for Profit. . . . Any position held by a commodities dealer or any in regulated futures contracts shall be rebuttably presumed to be part of a transaction entered into for profit’’ (emphasis supplied). TRA 86 amended section 108(b) by eliminating the rebuttable presumption and inserting an irrebuttable one, providing, ‘‘(b) Loss Incurred in a Trade or Business. . . . Any loss incurred by a commodities dealer in the trading of commodities shall be treated as a loss incurred in a trade or business’’ (emphasis added). The Tax Court nonetheless concluded that ‘‘Congress never intended section 108(b) to automatically characterize all dealer derived straddle losses as losses incurred in a trade or business.’’ Fox v. Commissioner, T.C. Memo. 1988-570. (Horn’s claims were consolidated with several other taxpayers’ in Fox. Several of the other taxpayers involved in Fox appealed the Tax Court’s adverse decision, but only the D.C. Circuit refused to apply a free-floating doctrine. See, e.g., Lerman, 939 F.2d at 52; Gardner v. 954 F.2d 836, 838 (2d 1992)). 82968 1231. 83Id. 84Id. 85Id. 86Id. 87Id. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT substantive" in order 79 the D.C. Circuit parted ways with nontax benefit.72 concluded that the economic substance doctrine that its ""the plainly expressed the legisdisregarding sham transactions for federal taxation pur-lature."80 case poses continues in full force today, with no exception for the Deficit Reduction Act) created an irrebuttable presection deductions," "economic sumption commodities dealers, the taxpayer, substance is a prerequisite to any Code provision allowing had a business purpose when engaging in some taxdeductions."73 It further the Court's motivated straddle transactions, stating that any losses decision in Knetsch v. United States "plainly contra-"treated loss dict[ed]" Wexler's arguments 74 thus set aside the in a trade or business."81 nonedistrict judge's to genuine indebted-theless taxpayer's ness, finding "instruction render the disqualified substance] doctrine inert" "benefits. the overwhelming weight of the relevant case law."75 Wexler demonstrates that foating economic to give credence the statute's irrebuttable doctrine can apply criminal cases. That presumption and its application of a free-foating eco-Wexler's might in-nomic substance test was "plainly and simply wrong" 82 debtedness within meaning of section 163(was was "inconceivable that Congress irrelevant so long as his transaction did not meet the [economic substance] doctrine be laid over the statute."83 judicial was facing had "d] charges. that the appli-whether Congress intended the 'loophole "'84 offered by cation doctrine in the statute and had thereby taken the doctrine "too far"85 case is repugnant to the Constitution,76 but the govern--his interpretation read the statute "completely ment continues to argue that it is a proper part of a existence."86 The court was thus "at a loss to understand criminal trial,77 and the lower courts usually agree.78 Commissioner's several [economic substance] doctrine applies section 108."87 concluded Not all lower courts view the economic substance principles F.2d 1229, 1236 (D.C. Cir. 1992). 72Id. at 127. 80Id. at 1231. 73Id. at 127. 81See Tax Reform Act of 1986, P.L. 99-514, section 1808(d), 100 74Id. 123. For a discussion of Knetsch, see infra Part IILB. Stat. 2817 (1986). Section 1808(d) of TRA 86 amended section 108 75Id. at 127. of the Deficit Reduction Act of 1984 (DRA), P.L. 98-369, 98 Stat. 76See United States v. Dahlstrom, 713 F.2d 1423, 1429-1430 (9th Before amendment, section 108 provided Cir. 1983), cert. denied, 104 Sup. Ct. 236 (1984). ("These appellants commodities certain regulation a business b) of advocacy "Presumption Transaction Into foreign trust corporations as would Profit... position held by a commodities person regularly engaged in investing in regulated futures lack economic for purposes of a civil presumed to part for of profit" (emphasis supplied). TRA 86 amended of any evidence of a specific intent b) by eliminating amendments providing, "(b) Loss Constitution.") Business... loss incurred by a commodities 77See Michael J. Garcia, "Government De-trading of commodities shall be treated as a loss fendants' to Dismiss Indictment," Doc 2006-4307, 2006 a trade or business" (emphasis added). The Tax TNT 44-9 (Mar. 3, 2006). ("Long Term Capital and Ingredient nonetheless "Congress and other cases dispose of defendants' claims ... b) to all economic substance over incurred business." Fox v. are not properly part of a criminal case or are vague and T.C. Horn's conunknowable. Ingredient Technology hardly paused in approving solidated several taxpayers' Fox. Several case, Fox appealed Tax Court's par7s8ing the exact distinctions among them was unimportant.") decision, but only See, e.g., United States v. Atkins, 869 F.2d 135, 139-140 (2d Cir. doctrine. See, e.g., Lerman, 939 F.at 52; Gardner ("Appellants' contention court's Commissioner, 954 F.2d 836, 838 (2d Cir. 1992)). on has no place in 82968 F.2d at 1231. prosecution is without merit."); United States v. Manko, 83Id. at 1231. 979 F.2d 900, 905 (2d Cir. 1992) (observing that the district court 84Id. at 1238. "the government the jury 85Id. at 1231. found either that the transactions 116Id. at 1234. lacked economic substance"). 87Id. at 1238. 976 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315‘‘for divining and effectuating congressional intent, not for supplanting it,’’88 and found in favor of the taxpayer. Despite the D.C. Circuit’s strong statements, Coltec, In and Wexler represent the typical approach among the lower courts. The D.C. Circuit has been expressly criticized for its focus on statutory language,and the economic substance doctrine serves as an additional hurdle that a taxpayer must jump whenever he seeks a tax benefit under the code.90 Acourt may taxpayer’s motion judgment on statutory issues, but then address the economic substance doctrine in a separate proceeding and deny the taxpayer statutory benefits anyway.91 And even if Congress substance into a statute, the lower courts may apply an additional test regardless.92 The doctrine not only floats over the Internal Revenue Code, but can even be used to shortcircuit the Administrative Procedure Act’s notice-andcomment rulemaking procedures.93 Indeed, as then-Judge Breyer wrote on behalf of the First Circuit in Dewees v. Commissioner, the economic substance doctrine ‘‘outside framework.’’94 Although courts sometimes pause before asserting ‘‘the power to rewrite laws enacted by Congress and the President,’’95 economic doctrine frequently invoked to deny taxpayers benefits, even when 88Id. 89See, e.g., Krumhorn v. Commissioner, 103 T.C. 29, 50, Doc 6826, 94 TNT 10 (1994). (‘‘We disagree with the holding Horn and hold, consistent with our prior cases and all other circuit courts that have reviewed this matter . . . that it is appropriate before applying the per se rule of section 108(b) to inquire whether the straddle transactions at issue are devoid of economic substance.’’) At least one judge on the D.C. Circuit continues to believe that courts must examine statutes in deciding tax cases. See Transcript of Oral Argument at 29-30 (Oct. 2, 2001), Saba Partnership v. Commissioner (No. 00-1328, 00-1385) (remarks of Judge Harry Edwards). (Horn ‘‘makes it very clear the D.C. Circuit is at odds with the Third Circuit. [We are not] going to call it a sham without regard to what the statute says. Horn completely rejects that, and we rejected the Third Circuit in Horn.’’) For a longer discussion of the D.C. Circuit’s refusal to apply a free-floating doctrine, see Durham, Williamson, and Thiel, ‘‘Mrs. Gregory’s Great-Grandchildren: The Lost Generation,’’ Taxation of Global Transactions 25, 31-35 (Summer 2002). 90See, e.g., ACM, 157 F.3d at 254 n.44 (economic substance test required even if ‘‘statute is drafted in broad terms that do not require a particular intent or purpose’’), and Lerman, 939 F.2d 44 at 91In Klamath Strategic Investment Fund, LLC v. United States, 608, 615-Doc 2006-140-(E.D. Tex. 2006), the court rejected the government’s arguments and found that the taxpayer’s transaction complied with the statute. The court examined the application of the free-floating a separate Klamath Strategic Investment Fund, LLC v. United States, __ F. Supp.2d __, 2603, 2007 TNT 22-9 (E.D. Tex., 2007), and held the id. (‘‘The court’s [previous] summary judgment ruling determined that the tax treatment and accounting technically complied with Section 752 . . .At issue still is whether the transactions were shams or lacked economic substance.’’) 92See, e.g., Duke Energy v. States, 837 (W.D. N.C. 1999). In Duke Energy, the court applied an economic substance test on top of a statute which already contained an economic substance test. In that case, the taxpayer had claimed a dividends received deduction (DRD) under section 243. Although section 246(c) plainly provides an economic ‘‘risk of loss’’ test that limits the availability of the DRD under section 243, the court nonetheless began its analysis with the freefloating economic substance doctrine, as articulated by the Fourth Circuit in Rice’s Toyota, 752 F.2d at 91. Only after completing that analysis did the court examine the test found in 246(c), finding in favor of the taxpayer. 93In H.J. Heinz Co. and Subsidiaries v. United States, 76 Fed. Cl. 12834, 2007 TNT 103-16 (2007), the Claims Court exercised authority purportedly granted only to the Treasury secretary. In that case, Heinz’s subsidiary (HCC) sought to shelter over $100 million in income through a transaction that had objective economic substance but was probably designed solely to reduce taxes. HCC acquired Heinz stock from the public, held it for four months, and then sold most of that stock to its parent. Through peculiarities in the code, Heinz’s payment in exchange for that stock was treated as the payment of a dividend, rather than as a distribution in exchange for stock. See section 302(d). In turn, HCC’s basis in the stock that it sold jumped to the stock that it retained, and the retained stock consequently had a basis well in excess of its fair market value. See reg. section 1.302-2(c). HCC later sold its remaining Heinz stock to an unrelated party, claiming a large loss on the sale, but the IRS disallowed that loss. At trial, the taxpayer cited 21 statutes in support of its claim (see Plaintiff’s Initial Post-Trial Brief at iii) but the Claims Court glossed over the taxpayer’s statutory arguments in a single footnote. See 76 Fed. Cl. at 591, n.36. The court instead invoked numerous free-floating doctrines (including the economic substance doctrine) to disregard the fact that the taxpayer’s transaction had ‘‘complied with each and every of the relevant requirements imposed by the Code.’’ 76 Fed. Cl. at 592. Congress had actually enacted a specific statute saying that there is no basis reduction on account of ‘‘extraordinary dividends’’ when those dividends are paid between members of an affiliated group. See section 1059(e)(2)(A). The code’s plain language thus left no doubt that, absent the issuance of regulations and regardless of the presence or absence of business purpose, HCC did not have to reduce the basis in the stock that it retained after the initial sale to Heinz. (Were it not for the section 1059(e)(2)(A) exception, HCC would be prevented from creating a built-in loss on the retained Heinz stock.) However, Congress did give the secretary the authority to change that result by regulation. See section 1059(e)(2)(A) (rule requiring basis reduction on account of ‘‘extraordinary dividends’’ does not apply to dividends between affiliated except as regulations). secretary did not issue regulations until after the tax year at issue in Heinz, the taxpayer argued that it was entitled to its desired tax treatment. The court nonetheless found against the taxpayer, essentially implementing a rule that Congress said could apply only if notice-and-comment rulemaking procedures were followed. 94870 2d 1989) (Breyer, J.). 95See Jacobs Engineering Group, Inc. v. United States, not in F. Supp., 1997 WL 314167, Doc 97-(C.D. Cal. 1997). (‘‘Though it is a well-settled rule designed to negate the tax consequences of sham transactions, [economic substance] is a somewhat disturbing doctrine. First, [the doctrine] defeats settled expectations for taxpayers already struggling to traverse a wildly complex tax code. Second, the doctrine is fundamentally anti-majoritarian, as unelected bureaucrats are given the power to rewrite laws enacted by Congress and the COMMENTARY /next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT "divining and effectuating congressional shortfor it,"88 favor of the taxpayer. circuit the Administrative Procedure Act's notice-and-Circuit's strong statements, Coltec, comment rulemaking procedures 93 then-re CM Holdings, Compaq, and Wexler represent the typical Breyer wrote on behalf of the has v. Commissioner, the economic substance doctrine criticized for lan-"takes a transaction outside the statutory framework."94 guage,89 and the economic substance doctrine generally courts sometimes pause "as an additional hurdle rewrite laws enacted by Congress the he seeks the code.90 A court President,"95 the economic substance doctrine is fremay even grant a taxpayer's motion for summary judg-quently to deny taxpayers benefits, ment issues, then address economic doctrine proceeding anyway91 And expressly incorporates an economic substance test 93In J Co. 570, Doc 2007-12834, 2007 TNT 103-16 (2007), the Claims Court 92 The doctrine not only foats authority purportedly to the Treasury In case, Heinz's subsidiary million a transaction but designed 88 reduce Id. at 1234. for four months, and then sold most 89See, e.g., Krumhorn Commissioner, Heinz's 94-6826,94 TNT 140-10 (1994). ("We disagree with the holding in exchange for a with prior cases other rather than as a in exchange for stock. See reviewed this matter ... appro-302(d). In turn, HCC's in that priate the per se b) to inquire the stock that it retained, and the retained stock straddle transactions eco-well of its fair nomic substance.") At one judge D.Circuit reg. section 1.302-2(c). HCC later sold its remaining to courts must examine statutes a large loss cases. Transcript of Oral at 29-30 At the taxpayer cited v. Commissioner in its claim (see Plaintiff's Post-Harry "but the Claims Court glossed over the taxpayer's Circuit odds with We arguments in a single footnote. See 76 at 591, a sham regard what the numerous free-docstatute rejected trines the economic substance in Horn.") For a longer discussion of the D.C. taxpayer's transaction had "each Circuit's apply a free-doctrine, see Code." Thiel, "Mrs. Gregory's Great-Grandchildren: had specific Generation," Taxation of Global Transactions 25, 31-basis account 2002). "dividends" when those are be-90See, e.g., ACM, 157 F.3d at 254 n.44 (economic substance tween an affiliated group. See section 1059(if "code's that, absent intent or purpose"), and Lerman, 939 F.of presence abat 52. sence of business purpose, HCC 91In United States, sale to Heinz. (Were 440 F. Supp.2d 608, 615-17, Doc 2006-13753, 2006 TNT 140-14 not for the section 1059(A) HCC be 2006), the court rejected the government's loss retained the taxpayer's did the authority court change result by regulation. See section economic substance doctrine in a separate proceeding, Klamath basis "extraordinary Investment Fund, LLC v. United States, -F. Supp.2d -, dividends" apply to dividends between affiliated Doc 2007-2603, 2007 TNT 22-9 (E.D. Tex., 2007), and held against corporations, except as provided in regulations). Because the secthe taxpayer. See id. ("The court's [previous] summary judgment retary not issue after the tax year at issue determined that the tax treatment and accounting tech-that it nically Section ... issue substance.") could e.g., Duke Energy v. United States, 49 F. Supp.2d 837 if notice-and-procedures fol-Energy, the court applied lowed. test on top 94870 F.2d 21, 34 (1st Cir. 1989) (Breuer, J.). test. In the taxpayer 95See Jacobs Engineering Group, Inc. v. United received section Al-reported in F. Supp., 1997 WL 314167, Doc 97-9341, 97 TNT 64-6 though c) plainly "risk ("is a well-settled rule designed loss" of the DRD under section consequences transactions, economic began its with free-is a somewhat disturbing docfloating economic doctrine, as articulated trine] defeats strug-Circuit in Rice's Toyota, 2d after gling complex tax code. Second, found anti-majoritarian, as unelected bureaucrats favor of the taxpayer. to rewrite laws enacted by Congress (Footnote continued on next page.) TAX NOTES, September 10, 2007 977 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315they have ‘‘complied with each and every of the relevant requirements imposed by the Code.’’96 III. The Supreme Court’s Approach Acareful review of the Supreme Court’s jurisprudence that floating economic substance test to tax statutes. Rather, the Court principles only extent that the applicable statute makes those principles relevant. In other words, the Court examines economic substance principles to determine whether a taxpayer’s conduct falls within a statute’s terms. The Court does not floating doctrine despite their ‘‘with the code,’’ nor does the Court announce that analysis of ‘‘details’’ is unnecessary. Before discussing the Court’s approach, however, three disclaimers are again required. First, the facts and statutes in the following discussion have been simplified to highlight the Court’s method of interpretation. Much has been written about the Court’s substantive results, but those results are not the primary focus here.97 Second, while the cases discussed below paint a consistent picture, the Court has added requirements beyond those previously contemplated by Congress.98 ‘‘It is much too late to deny that there is a significant body of federal law that has been fashioned by the federal judiciary in the common-law tradition.’’99 Nonetheless, the focus here is on the application of the economic substance doctrine, and the Court uses economic substance principles only to the extent that a plausible statute makes Third, and perhaps most important, the following discussion takes the Supreme Court’s opinions at face economic substance cases ‘‘mean all things to all men,’’100 this report assumes that In of the following the Court explicitly and so on) the of the governing statutes. Perhaps those principles were really imposed by the individual justices and had no basis in the statute, but interpretations based on legal are not given consideration here.101 Gregory discussion of the economic substance begin, of course, with Gregory v. Helvering.102 reorganization the taxpayer, Gregory. Gregory wished to extract Monitor Corp. stock held by owned corporation (UMC) so that she sell that stock in her individual capacity. If UMC had sold the stock, two levels of tax would have been imposed — one on the corporation’s sale of the stock and another on the corporation’s distribution of the proceeds to Gregory. not however.103 She thus tried to ‘‘bring about a [tax-free] ‘reorganization’ under section 112(g) of the Revenue Act.’’104 She caused UMC to create a transitory entity, Averill, to which UMC transferred the Monitor stock. Averill simultaneously issued all of its shares to Gregory. Gregory then liquidated Averill and claimed a fair market value basis in the Monitor stock she received in that liquidation. She then sold that stock to a third party. Section 112 provided that stock received ‘‘in the pursuance of a plan of reorganization’’ results in no gain or loss recognition to a shareholder.105 Gregory argued that involving fact reorganization, Averill’s transitory existence. The commissioner countered that must be disregarded that Gregory was ‘‘liable for a tax as though [UMC] had President. Finally, the doctrine blatantly favors the Commissioner, as no taxpayer would dare make a substantive tax deduction in the absence of proper form. Such a taxpayer would risk tax penalties, or worse. Simply put, this doctrine paves a one-way street upon which only the Commissioner may travel.’’) 96See Heinz, 76 Fed. Cl. 97See supra note 9 for articles discussing the Court’s opinions in further detail. 98See, e.g., Paulsen v. Commissioner, 469 U.S. 131, 144 (1985) (O’Connor, J., dissenting) (criticizing ‘‘judicially imposed ‘continuity-of-interest’ doctrine’’). 99Northwest Airlines v. Transp. Workers Union, 451 U.S. 77, 95 100Charles S. Whitman, ‘‘Draining the Serbonian Bog: ANew Approach to Corporate Separations Under the 1954 Code,’’ 81 L. Rev. (1968). 101See TransWorld Airlines, Inc. v. Franklin Mint Corp., 466 U.S. 243, 282-283 (1984) (Stevens, J., dissenting). (‘‘Some students of the Court take for granted that our decisions represent the will of the judges rather than the will of the law. This dogma may be the current fashion, but I remain convinced that such remarks reflect a profound misunderstanding of the nature of our work.’’) Even if the economic substance cases were decided in a results-oriented fashion, however, it is the opinions themselves (and not the hidden motives of the justices) that carry the imprimatur of the Court and that the lower courts must follow. 102293 1935). 103Through the operation of provisions not relevant here, Mrs. Gregory actually did incur some taxes under her purported reorganization. See 293 U.S. at 467. 467. 105See id. at 468: The provisions of the section, so far as they are pertinent to the question here presented, follow: ‘‘Sec. 112. * * * (g) Distribution of Stock on Reorganization. If there is distributed, in pursuance of a plan of reorganization, to a shareholder in a corporation a party to the reorganization, stock or securities in such corporation or in another the reorganization, surrender by such shareholder of stock or securities in such a corporation, no gain to the distributee from the receipt of such stock of securities shall be recognized. * * * (i) Definition of Reorganization. As used in this section * * * ’’(1) The term ‘‘reorganization’’ means * * * (B) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred.’’ COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT "each statute, interpretations based by the Code."96 realism are not given consideration here.101 A. Gregory v. Helvering The Supreme Court's Any discussion of the economic substance doctrine A careful Court's must begin, of course, with Gregory v. Helvering.102 In a reveals that the Court has never applied a free-foating two-page opinion, the Court examined a purported reoreconomic the Court ganization undertaken by the taxpayer, Evelyn Gregory. examines principles of economic substance only to the her wholly owned corporation (UMC) so that she could words, the Court examines economic in her individual capacity. principles taxpayer's two levels of tax would have been imposed -a statute's terms. corporation's use a free-floating economic substance doctrine to deny corporation's of the proceeds to Gregory. taxpayers benefits despite their "mere compliance with Gregory preferred not to pay any taxes at all, howthe code," ever.103 She thus tried to "bring about 'reor-"statutory details" is unnecessary. ganization' under section 112(g) of the Revenue Act."104 caused UMC to a transitory entity, Averill, Court's approach, however, Averill simul-taneously in discussion simplified and claimed a fair market value basis the Court's stock she She written the Court's substantive results, party. those the primary focus here.97 112 provided that stock received "in pur-while cases below suance of a plan of reorganization" picture, has added requirements to a shareholder.105 Gregory argued contemplated by Congress.98 "the transfers involving Averill were in fact made in the a significant pursuance of a plan of reorganization, despite Averill's that has been fashioned the federal existence. in the common-law tradition."99 Nonetheless, the transfers involving Averill must be disregarded and the application of the economic "doctrine, and uses economic principles only to extent a plausible reading of the governing statute makes them relevant. 101 See Trans World Airlines, Inc. v. Franklin Corp., 466 S. perhaps 283 (1984) (Stevens, J., dissenting). ("Some students Court's face decisions the will value. While economic substance cases have come to of the law. "things to all men,"100 assumes remain convinced that such remarks the opinions mean what they say. In each of the following of the cases, the Court explicitly grounds its application of work.") Even if the economic economic substance cases economic substance principles (business purpose, risk themselves assumption, profit motivation, and so on) in the language hidden motives the justices) carry the statutes. imp1r0i2matur of the Court and that the courts 293 U.S. 465 (1935). justices no 103Through provisions not relevant here, incur some reorganization. See 293 U.S. at 467. 104Id. at 467. Finally, the Commis-105See id. sioner, as dare make a substantive section, the of proper a taxpayer would "Sec. 112. this doctrine paves of Stock on Reorganization. disone-way upon only the Commissioner may tributed, pursuance of reorganization, travel.") 96 See Heinz, 76 Fed. Cl. at 591. securities another 97See supra note 9 for articles discussing the Court's opinions corporation a party to the reorganization, without the detail. 98See, e.g., Paulsen v. Commissioner, S. no O'Connor, J., dissenting) "judicially imposed 'interest' doctrine"). of Reorganization. section 99Northwest Airlines "(1) The "reorganization means (B) (1981). a part of its assets 10 Charles Whitman, "the Serbonian A New Corporate Separations the 1954 Code," 81 Harv. L. Rev. 1194, 1258 n.9 (1968). which the assets transferred." 978 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315paid her a dividend consisting of the amount realized from the sale of the Monitor shares.’’106 The Court acknowledged that Gregory’s tax motive was irrelevant. Instead, ‘‘the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.’’107 It thus examined whether the transfers involving Averill constituted a reorganization within the meaning of the statute. The Court found that, via the operation of section 112(g), transfers described in section 112(i)(1)(B) must be made in the pursuance of a business plan to constitute a reorganization; made only from a corporation could not qualify. The Court stated: (B) speaks of a transfer of assets one corporation to another, it means a transfer made ‘a plan of reorganization’ (section 112(g)) of corporate business; and not a transfer of by one corporation pursuance of a plan having no relation to the business of either, as plainly is the case here. Putting aside, then, respect altogether, the character actually occurred, what do we find? Simply an no business — a mere device which put on the form of a concealing its real character, and the sole object and of which was the consummation of plan, not of a business, transfer a parcel of corporate petitioner.108 Although many lower courts have concluded otherwise,the Court did a free-floating substance doctrine in Gregory. Rather, the Court found (rightly or wrongly) that the statute itself demanded a business purpose. Section 112(i)(1)(B) (as amplified by section 112(g)) required that a reorganization be conducted corporate business in order to qualify for tax-free treatment. That Gregory’s transfers were performed in accordance with was of little — those part ‘‘to reorganize or any part business.’’110 Because Averill’s existence was merely transitory, the transfers involving the corporation could not be a part of a plan to reorganize a business. The Court taxpayer’s and Second Circuit’s holding ‘‘that there had been no ‘reorganization’ within the meaning of the statute.’’111 It closed its opinion by reiterating that Gregory did not comply with section 112, stating that her transaction ‘‘its face of the statute. To hold otherwise would . . . deprive the statutory provision in question of all serious purpose.’’112 It is hard to see how a holding that is rooted in the ‘‘question’’ indicates courts should ignore statutory provisions.113 It is even harder to see how an opinion that puts aside ‘‘the question of motive in respect of taxation altogether’’ indicates that a tax avoidance motive disqualifies a enjoying statutory benefits. Gregory does not give courts the right to disregard Congress’s statutes, and the lower courts’ contrary interpretation exalts artifice above reality.114 The Federal Circuit pointed to no applying its economic substance Supreme in Gregory expressly grounded its economic substance analysis in the language of section 112(i).115 The Third Circuit did not perform any statutory analysis holding against Camelot and considered Camelot’s tax avoidance ‘‘damning’’; the Supreme parsed language of sections 112(g) and 112(i)(1)(B), and refused to Gregory’s did not even cite any of the statutes implicated by Compaq’s in Gregory quoted section 112 at length. Gregory offers no support for that ‘‘economic substance is a prerequisite the application of any Code provision allowing deductions.’’116 One might nonetheless argue that because the Court did not interpret section 112 literally, it ignored the statute in reaching its holding. But although the Court a literal interpretation (it ‘‘pursuance plan’’ referred to the pursuance business plan and not literally any plan), that does not mean it created a judicial doctrine. For example, if a statute provides that a taxpayer must ‘‘walk three steps’’ and that ‘‘steps’’ ‘‘three steps and dance,’’ a judicial has, at most, misinterpreted the statute. To create a judicial doctrine, the Court would have to say that ‘‘although the words ‘walk three steps’ mean ‘walk three 467. 107Id. 469. 108Id. 109See, e.g., Stauffer’s Estate, 403 F.2d 611 at F.2d at 52; ACM, 157 F.3d at 246; Killingsworth v. Commissioner, 2d (1989). 110Id. 469. 111Id. at 468 (citing 69 F.2d 809 (2d Cir. 1934)). 470. 113See also Isenbergh, ‘‘Musings on Form and Substance in Taxation,’’ 49 U. Chi. L. Rev. 859, 874 (1982). (Gregory is ‘‘couched in the language, at least, of traditional statutory interpretation. purports to be striving for tax statute.’’) 114See 2 Martin Ginsburg and Jack Levin, Mergers, Acquisitions and Buyouts, para. 609.1 (2003) (‘‘It is doubtful that the Gregory to create of the sort that now the tax law. . . . [T]he Court framed the issue as ‘whether what was done, apart from tax motive, was what the statute intended.’’’); Durham, supra note 89, at 26 (‘‘The expansive reading of Gregory to or ‘generic’ test of economic substance has no basis in Gregory itself . . . Mrs. Gregory’s lack of business purpose was relevant only because the statute by its very terms required purposive conduct, i.e., that her actions be ‘‘‘in pursuance of a plan of reorganization’ . . . of corporate business.’’’). 115See also John F. Prusiecki, ‘‘Coltec: More Points to Ponder,’’ Oct. 196-34. 116Lerman v. Commissioner, 939 F.2d at 52. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT dividend consisting the amount realized hold otherwise would ... provifrom the sale of the Monitor shares."106 sion in question of all serious Gregory's purIpt oiss eh.a"1rd1 2to see the ""statutory provision in question" indicates that lower motive, courts should ignore statutory provisions.113 It is even thing which the statute intended."107 thus opinion that puts aside "the transfers involving consti-respect of taxation altogether" tuted the meaning of the statute. tax avoidance disqualifies that, via the operation of section 112(taxpayer from enjoying statutory benefits. Gregory does section 112(to disregard Congress's statutes, the pursuance a business constitute courts' artireorganization; transfers made only to extract property fice above reality.114 The Federal Circuit pointed to no qualify. The Court stated: statutory language in applying its economic substance When subdivision (B) speaks of a transfer of assets analysis; the Supreme Court in Gregory expressly by one corporation to another, it means a transfer economic analysis in lanmade 'in pursuance of a plan of reorganization' (section guage section 112(i).115 not corporate business; and not a transfer bother to perform any statutory analysis in holding assets by one corporation to another in pursuance Camelot's plan having no relation to the business motives "damning"; the Supreme Court parsed the laneither, is the case here. Putting aside, then, guage g) i)(B), and the question of motive in respect of taxation altogether, examine Gregory's tax avoidance motive. The Tax Court and fixing the character of the proceeding by what not even cite any of the statutes implicated what do an Compaq's transaction; the Supreme Court in Gregory operation having no business or corporate purpose length. offers no support the argument that "economic substance is a prerequisite to -a mere device which the a deduc-corporate reorganization as a disguise for conceal-tions."116 ing its real character, the sole object and accomplishment of which was the consummation of a nonetheless preconceived plan, not to reorganize a business or any not interpret section ignored the part of a business, but to transfer a parcel of corporate shares to the petitioner.108 rejected a literal interpretation of the statute (it found that the "pursuance of a plan" referred to the pursuance of a many lower courts have concluded other-plan and not does wise,109 the Court did not create a free-floating economic created if doctrine Rather, the Court "three steps" or wrongly) that the statute itself demanded to secure a tax benefit, and the Court says that "walk Section 112(1)(three steps" actually means "walk three steps and a reorganization be con-dance," the Court has not created a judicial doctrine. It ducted in the pursuance of a plan relating to corporate most, misinterpreted statute. To create in for tax-free treatment. the say that Gregory's accordance with "'walk three steps' 'the form of a reorganization was of little consequence -the statute demanded that those transfers also be a part of a plan "to reorganize a business or any part of a business."110 Because Averill's existence was merely tran-112Id. at 470. sitory, involving 113See also Isenbergh, "Musings on a plan to reorganize a business. Taxation," 49 U. Chi. L. Rev. (Gregory is "thus rejected the taxpayer's arguments and affirmed the of traditional Circuit's holding "there 'reor-Gregory purports to be striving for the meaning of the tax ganization' within the meaning of the statute."111 statute.") 114 its See 2 Martin and Jack Levin, Mergers, Acquisicomply section 112, that her transaction tions ("is doubtful that the Supreme Court in Gregory intended to create a business purpose "upon its face lies outside the plain intent of the statute. requirement of the sort that now encumbers the tax law... the issue 'what was done, apart from motive, statute intended."'); Durham, ("Gregory 106Id. at 467. require an a priori, or 'generic' test of economic substance has 107108Id. at 469. basis Gregory ... Gregory's lack of business Id. (emphasis supplied). because by e.g., Staufer's Estate, 403 F.2d 611 at 621; Lerman, 939 be "'pursu-2d 157 F.at 246; Killingsworth v. Commissioner, ance of plan reorganization' ... of corporate business."'). 864 F.2d 1214, 1216 (5th Cir. 1989). 115See also John F. Prusiecki, "Coltec: More Points to Ponder," 110Id. at 469. Tax Notes, Oct. 9, 2006, p. 188, Doc 2006-20635, 2006 TNT 196-34. "'Id. at 468 (citing 69 F.2d 809 (2d Cir. 1934)). 116Lerman TAX NOTES, September 10, 2007 979 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315steps,’ we nonetheless demand that the taxpayer dance.’’ would of judicial As long as one is concerned with only the code’s reorganization provisions, the distinction just described might not mean much. Regardless of the origin of the a taxpayer needs to know is that it needs to meet that requirement for its transaction to qualify as a reorganization. But because the courts impose a business purpose requirement onto all tax statutes allowing deductions,117 it is critical to recognize that the Court’s application of economic substance principles was grounded in the statute itself. The Court in Gregory may have misinterpreted the statute,118 but it did not ignore it. B. Knetsch v. United States in Knetsch States transaction perhaps even bolder than Mrs. Gregory’s. at 3.5 the company at 2.5 and still made a profit.119 Knetsch did this by purchasing 10 annuity bonds (each with a 30-year term) from the each and by signing $4 million nonrecourse notes to cover the purchase price. The advance, increases in the annuity bonds’ payments. Before accounting for tax consequences, Knetsch was actually worse off as a result of the transaction—the increases in the bonds’ value did not completely offset his interest payments.120 However, the increase in the bonds’ value was tax-deferred, while the interest payments could be deducted as they were made. That timing from Knetsch deducted his interest payments under section 163(a).121 ‘‘interest paid . . . within the taxable year on indebtedness.’’ The government, however, denied Knetsch’s deductions, arguing constitute indebtedness within the meaning of section 163(a). Before examining the facts, the Court put aside the district court’s finding that Knetsch’s only motive in entering into the transaction was to secure a tax deduction.122 As in Gregory, ‘‘the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended,’’123 and Knetsch’s tax avoidance motive was therefore irrelevant. The Court then examined ‘‘the transaction between Knetsch and the created ‘indebtedness’ within the meaning of [section 163(a)], or whether, as the trial court found, it was a sham.’’124 The that no indebtedness had been created that the transaction resulted in only the ‘‘façade’’ of a loan.125 Knetsch had merely shuffled funds using the annuity bonds and the nonrecourse notes, and his transactions ‘‘did not appreciably affect his beneficial interest except to reduce tax.’’126 Actual indebtedness requires a ‘‘true obligation to pay interest,’’127 but Knetsch had no The Court agreed with the trial that there was ‘‘no commercial economic substance’’ to the transaction; ‘‘the parties did not intend that Knetsch ‘become indebted to [the insurance company]’’’ and ‘‘no indebtedness . . . was created by any of the transactions.’’129 relied on section 163(reaching its conclusion. It held that, because the parties did not create an actual indebtedness, no interest deductions by Knetsch — there was pay interest.130 That conclusion was grounded in a 117See id. 118The Court treated the statute’s operative provision (section 112(g)) as bearing on the construction of the definitional provision (section 112(i)), when in fact it should have done the reverse. Definitional provisions are not self-executing and can serve only to clarify the meaning of operative provisions. The ‘‘pursuance of a plan’’ language in section 112(g) should have had no bearing on the meaning of the word ‘‘transfer’’ in section 112(i)(1)(B). Cf. Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, para. 12.02[2] (7th Ed. 2002 and Supp. 2006). (‘‘Although section 368(a)(1) defines the term ‘reorganization,’ it does not of its own force have any operative significance. Its definitions become important only as they are employed in Code.’’) 119364 1960). 120Knetsch faced such a high tax rate that the arrangement, if respected for tax purposes, would nonetheless be profitable for him. For a comprehensive discussion of the Knetsch tale, see Daniel N. Shaviro, ‘‘The Story of Knetsch: Judicial Doctrines Combating Tax Avoidance,’’ Tax Stories 318 (Paul Caron ed., 121Section 23(b) of the 1939 code applied to one of Knetsch’s earlier tax years. That section had language substantially similar to that found in section 163(a) of the 1954 code. 122364 U.S. at 365. (‘‘We put aside a finding by the District Court that Knetsch’s ‘only motive in purchasing these 10 bonds was to attempt to secure an interest deduction.’’’) 123Id. 124Id. 125Id. 366. 126Id. (quoting Gilbert v. Commissioner, 248 F.2d 399, 411 (2d Cir. 1957) (Hand, dissenting)). 127Id. 367. 128Id. 366. 129Id. at 364-365 (punctuation omitted). 130This report’s reiterating here. Many commentators have concluded that Knetsch did meet all the statutory requirements but that the Court imposed an additional economic substance test to deny him the claimed benefits. But that is not what the Court said. Rather, the Court plainly held that Knetsch’s transaction did not create an ‘‘indebtedness.’’ See id. Knetsch’s transaction was required to have substance because the statutory term ‘‘indebtedness,’’ ordinarily understood, contemplates real borrowing, not merely any arrangement that a taxpayer labels as such. The Court thus rejected Knetsch’s contention that the arrangement resulted in legitimate borrowing. ‘‘It is patent that there was nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction. What he was ostensibly ‘lent’ back was in reality only the rebate of a substantial part of the so-called ‘interest’ payments.’’ Id. at 366. Because there was no real loan and no real interest, no genuine indebtedness had been created. See id. at 367-368. Nothing in the opinion suggests that, had Knetsch’s transaction created genuine indebtedness, the Court would ignore his ‘‘mere compliance’’ with the statute. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT steps,' demand dance." Knetsch's ar-That would be an instance of judicial lawmaking. guing his payments did not constitute interest paid on as one is concerned only the code's the meaning of section 163(a). just described the the Court aside mean of the origin court's that Knetsch's business purpose requirement, all that a taxpayer needs the transaction was to secure deducto is that it needs tion.122 As in Gregory, "the question for determination is as a But because lower courts impose a business purpose requirement which the statute intended,"123 Knetsch's deductions,117 it that Court's economic sub-"the stance principles insurance company to determine whether it created an Court in Gregory may have misinterpreted the statute,118 'indebtedness' the meaning of [section 163(not ignore court found, it was a sham."124 Court found that no indebtedness had been created and States resulted in "facade" The taxpayer in Knetsch v. United States engaged in a 125 had shuffed the Mrs. Gregory's. bonds and the nonrecourse trans-Knetsch borrowed funds at 3.5 percent from an insurance actions "not appreciably affect beneficial company, invested them with the company at 2.5 percent, tax."126 Actual made a 119 Knetsch did this "true obligation to pay interest,"127 but Knetsch had no with such obligation.128 The Court agreed with the trial court company for $400,000 each and by signing $4 million of "no commercial economic substance" notes to purchase The "that Knetsch interest payments on account of the notes were payable 'indebted to [company]"' "in advance, and Knetsch used amounts attributable to ... was created by any the transacincreases in the annuity bonds' value to make the pay-tions."129 ments. tax consequences, The Court plainly relied on section 163(a) in reaching a result of the transaction -that, because the did in the bonds' value did indebtedness, interest deductions 120 However, the in bonds' could be taken by Knetsch -there was no obligation to tax-the interest payments interest.130 was in deducted made. mismatch made the investment attractive, from a tax perspective. 122364 365. ("163(a).121 That section allows a deduction for "interest Knetsch's 'motive in purchasing these 10 ... within the taxable year on indebtedness." The secure deduction."') 123Id. 124125Id. Id. at 366. 126Id. v. Commissioner, 117See id. (Hand, 118The statute's (sec-127Id. at 367. tion g)) bearing on the of 128Id. at 366. (i)), when have 129Id. (punctuation Definitional are self-130This report's interpretive approach is worth reiterating only the meaning of operative provisions. The "plan" language in section 112(the meaning of the word "transfer" economic test to deny Cf Bittker and Eustice, Federal Income Taxation what the Court said. Rather, Shareholders, held that Knetsch's did "in-("section 1) debtedness." id. Knetsch's transaction was required 'reorganization,' does force because the statutory term "indebtedness," ordinarily Its important as are real borrowing, aremp1l9loved in other provisions of the Code.") rangement that thus 364 U.S. 361 (1960). Knetsch's contention that 120Knetsch a high tax rate that arrangement, "patent there for would be profitable to Knetsch this transaction For a comprehensive discussion of the Knetsch tale, see 'lent' back Shaviro, "The Story of Knetsch: Judicial Doctrines only the rebate of a substantial of the so-called Avoidance," Tax Stories ed., 'interest' payments." Id. at 366. Because 2003). genuine indebtedness had been created. 121Section b) of code applied Knetsch's id. 368. Nothing in suggests That section had language substantially similar Knetsch's found in section 163(a) of the 1954 code. ignore his "mere compliance" the statute. 980 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315common-sense interpretation of section 163(a)’s words, not in a judicial doctrine. If two parties do not intend to create and enforce a binding obligation, no ‘‘indebtedness’’ under section 163(a) can possibly be created. The Supreme Court’s approach in Knetsch is different lower courts’ approach in economic substance cases. Unlike the Third Circuit in In re CM Holdings, the Supreme Court did not declare that it could forgo an analysis of section 163(a).131 Instead, the Court expressly framed the issue as one of statutory interpretation.132 Unlike the Wexler court, the Supreme Court did not announce that Knetsch’s transaction could be ignored even if it resulted in genuine indebtedness.133 The Court Knetsch’s did ‘‘obligation to pay interest,’’134 but nothing in the opinion suggests that genuine indebtedness is insufficient to interest fact, suggests And unlike the Federal Circuit Coltec, the Court did not state that a subjective tax avoidance motive could disqualify the taxpayer from statutory benefits. Rather, the Court explicitly set aside court’s finding on Knetsch’s tax avoidance motive as irrelevant.136 The Supreme Court even acknowledged that Congress could grant favorable treatment to Knetsch’s sham transaction, but found nothing in the applicable statutes to suggest that Congress had done so.137 That the transaction lacked economic provided independent basis on which to deny Knetsch tax benefits — rather, it was the statute itself that required actual borrowing. But if the statutory language indicated that Congress did intend to grant favorable tax treatment to payments that were merely labeled as interest, the Court would give effect to that intent.138 C. United States v. Consumer Life Although the statute at issue in Knetsch demanded quite a bit of economic substance, not all statutes are as demanding. In United States v. Consumer Life Ins. Co., for example, the Court addressed whether a reinsurance transaction must shift economic risk in order to qualify for statutory benefits.139 The taxpayer in that case, Consumer qualified as a life insurance company under section 801(a). That section provides that an insurance company is considered a life insurance life insurance reserves 50 percent of its total reserves.140 Total reserves include life insurance reserves and unearned premiums not included in life insurance reserves.141 Stated simply, if more of an insurance company’s reserves insurance, it insurance company under section 801(a). Consumer Life had issued various accident and health policies to the public. Because the unearned premiums attributable to those policies did not pertain to life insurance, they made it more difficult for Consumer Life to qualify under section 801(a). To remove those its balance sheet, Consumer Life entered into a ‘‘treaty’’ with another insurance company, American Bankers. American Bankers became insurer the H polices, but Consumer Life (as reinsurer) retained all the risk. Nonetheless, unearned premiums from the A&H policies on its books.142 The government rejected the parties’ allocation of unearned premiums and contended that they must be to Consumer Life.143 would prevent Consumer Life from qualifying as a life under section 801.144 Gregory and Knetsch, the government argued that the treaty reflected a ‘‘sham transaction without economic substance and therefore should not be recognized for tax purposes.’’145 The Court dismissed the government’s arguments. It noted that the treaty was entered into after an arm’slength negotiation between unrelated companies.146 It also found that the treaty served basic business purposes and provided various economic benefits to Consumer Life.147 The Court acknowledged that ‘‘tax considerations well may have had a good deal to do with the specific terms of the [treaty], but even a ‘major motive’ to reduce not vitiate an otherwise substantial transaction.’’148 nonetheless substance. It argued that the Court should adopt a ‘‘reserves follow the risk’’ rule, such that the unearned premium must be allocated to Consumer Life, the ultimate risk-bearer. Although the Court acknowledged that the government’s to ‘‘logic,’’ 131See In re CM Holdings, supra Part II.B. 132See 364 U.S. at 361. (‘‘This case presents the question of whether deductions from gross income claimed on petitioners’ 1953 and 1954 joint federal income tax returns . . . constituted ‘interest paid on indebtedness’ within the meaning of . . . 163 (a) of the Internal Revenue Code of 1954.’’) Wexler, supra Part 134364 U.S. at 367. (‘‘The petitioners thus would attribute to Congress a purpose to allow . . . payments under transactions of the kind carried on by Knetsch with the insurance company without regard to whether the transactions created a true interest.’’) 135The expressly acknowledged that arrangements which create actual indebtedness would give rise to interest deductions. See id. at 367. (‘‘There may well be single premium annuity arrangements with nontax substance which create an ‘indebtedness’ for the purposes of section 163(a). . . . But this one is a sham.’’) 136See supra note 122. 137Id. at 367. (‘‘We . . . look to the statute and materials relevant to its construction for evidence that Congress meant . . . to authorize the deduction of payments made under sham transactions. . . . We look in vain.’’) 138Id. 139430 1977). 727. 141Id. 729. 142See id. at 734. 143See id. at 731. 145Id. 736-737. 737. 147Id. 737-739. 739. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT interpretation section 163(a)'In United States v. Consumer parties addressed a reinsurance and enforce a binding "indebted-must shift risk in ness" section 163(be created. statutory benefits.139 The taxpayer case, Con-Court's Knetsch is sumer Life, claimed that it qualified as a life insurance from the lower courts' approach in economic substance section provides Unlike the Third In re CM Holdings, considered life insurance Court did that it company if its life insurance reserves comprise more than analysis of section 163(a).131 Instead, the Court expressly its total reserves.140 framed the issue as one of statutory interpretation.132 insurance and premiums in-Wexler Court did cluded in life insurance reserves.141 Stated simply, if Knetsch's than half of an insurance company's reserves do not even if it resulted in genuine indebtedness.133 The Court pertain to life insurance, it cannot qualify as a life found that Knetsch's transaction did not create a "true under section 801(obligation to pay interest,"134 but nothing in the opinion that is (A&H) policies to the public. Because the unearned warrant interest deductions. In fact, the opinion suggests the exact opposite.135 And unlike the Federal Circuit in it Consumer the Court did state that a subjective tax to qualify under section 801(a). To remove those motive could taxpayer unearned premiums from its balance sheet, Consumer the Court set aside entered a "treaty" with another insurance the district court's finding on Knetsch's tax avoidance Bankers. Bankers became motive as irrelevant.136 the primary insurer on the A&H polices, but Consumer Court the risk. Nonetheless, grant Knetsch's trans-American Bankers included the unearned premiums from the A&H policies on its books.142 action, nothing in the applicable statutes the parties' Congress done so.137 That lacked economic substance provided no independ-be allocated entirely to Consumer Life.143 That reallocation ent on which to deny Knetsch tax benefits -was the statute required actual prevent Life insurance company under section 801.144 Citing Gregory language favorable Knetsch, the argued that treaty interest, the Court "sham transaction economic sub-effect to that stance and should intent.138 purposes."145 States v. Consumer government's the statute at issue in Knetsch demanded into afer an arm'squite of economic substance, all statutes are as length negotiation between unrelated companies.146 It the treaty served basic various economic benefits Consumer Life.147 The Court acknowledged that "tax considerations considerations 131 may have the specific See In re CM 132See 364 361. ("case 'motive' gross petitioners' taxes will not vitiate an otherwise substantial transac-and 1954 joint federal income tax ... tion.11148 'indebtedness' within ... 163 The government nonetheless demanded more subof Revenue 1954.") stance. It a "reserves 133See Wexler, supra Part II.D. the risk" rule, such that the unearned 134364 U.S. at 367. ("The petitioners thus would reserves must be allocated to Consumer Life, the ultimate a purpose to allow ... Although carried on by Knetsch with the insurance company regard to whether the transactions created true government's position appealed to "abstract logic," the obligation to pay interest.") 1.5The Court expressly acknowledged that arrangements create would interest id. at 367. ("There may well be single premium 139430 U.S. 725 (1977). arrangements nontax substance create 140Id. at 727. 'indebtedness' for section a)... 141Id. at 729. sham.") 1`2See id. 136See supra 143See id. 137Id. ("... the statute and materials 144See id. its construction for evidence that Congress 141Id. at 736-737. ... to authorize the deduction of payments 146Id. at 737. transactions... look in vain.") 147Id. at 737-739. 138Id. 148Id. at 739. TAX NOTES, September 10, 2007 981 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315relevant issue was ‘‘whether Congress intended a ‘reserves follow the risk’ rule to govern determinations under section 801.’’The statutory language indicated no such intent: There is no suggestion in the plain language of the section [of a ‘‘reserves follows risk’’ rule] . . . If language a substantial obstacle accepting the Government’s position. The word ‘‘risk’’ does not occur.150 Because the statute did not provide a risk requirement, the Court had no basis to invent one, even if that requirement was ‘‘logic[al].’’151 If the Court had decided Consumer Life in the way that courts decide economic substance cases, Consumer Life would have lost. Consumer Life had a significant tax-reduction motive, and it did not shift risk through its transactions. Either of those factors alone could disqualify the company from favorable tax treatment under the lower courts’ free-floating test.152 However, examined the applicable statutes Congress’s intent, not its own, nothing to suggest that the legislature required riskshifting or the absence of a tax-reduction motive as a prerequisite to the enjoyment of tax benefits under section 801. D. Frank Lyon v. United States economic was irrelevant in Consumer Life, that does not mean it is always irrelevant. If Congress makes risk-taking prerequisite a statutory benefit, the taxpayer must bear the required risk. That principle is illustrated by Frank Lyon v. United States.153 Frank Lyon, taxpayer a saleleaseback agreement with a commercial bank (Worthen). Worthen wished to purchase a building out of which to from doing so.154 The government did offer conditional approval of a sale-leaseback transaction, however. Worthen thus purchased a suitable piece piece was constructed. On the building’s completion, Frank Lyon immediately leased the building back to Worthen.155 Under the parties’ agreement, Worthen had an option to purchase the building at the end of the lease. Worthen that option simply FMV of the building when the lease was entered. Thus, in the likely event that the building appreciated, Worthen could purchase the building at a below-market price. If Worthen did not wish to exercise that option, it could renew the lease at highly favorable terms. Worthen was economic in the building, one of the most valuable rights associated with ownership in property.156 Lyon nonetheless claimed that it was the owner of the and that it was entitled to take depreciation deductions under section 167.157 The Eighth Circuit, in accordance with the government’s contentions, disagreed and concluded that ‘‘the benefits, risks, and burdens which [Lyon] has incurred with respect to the Worthen building are simply too insubstantial to establish a claim to the status of owner for tax purposes.’’158 The Supreme Court performed an intensely factual parties’ arrangements. observed that it would not: permit the transfer of formal legal title to shift the incidence of taxation attributable to ownership of transferor over transferred. In applying this doctrine of substance over form, the Court has looked to the objective economic particular form the parties employed.159 Although Lyon was not the owner of the property in the simple sense, the Court concluded that Lyon was the owner of property for purposes of section 167. The Court emphasized Lyon’s risk-bearing: No matter how the transactions could have been devised otherwise, it remains a fact that as the agreements were placed in final form, the obligation . . . squarely Lyon. Lyon, an ongoing its well-this real and substantial risk.160 The Court concluded that because Lyon’s ‘‘capital is invested in the building . . . it is Lyon that is entitled to deprecation deductions under section 167.’’161 It then reiterated its holding in more general terms: In short, we hold that where, as here, there is a transaction economic substance which is compelled or encouraged by or is shaped tax-avoidance have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated the parties. Expressed as significant 149Id. 740. 150Id. 151See 152See, e.g., Coltec, supra Part II.A. 153435 1978). 154See id. at 565. 155See 156See id. at 571. Worthen also had various other ownership rights in the property, which caused the Eighth Circuit to concluded that Frank Lyon had ‘‘toted an empty’’ bundle of ownership sticks and could not qualify for deductions under 570-536 157Section 167 generally allows the owner of property depreciation deductions on account of that property’s wear and tear. Section 167(a) does not explicitly provide an ownership requirement, but one is implied by a fair reading of the statute. 158435 536 F.754). 159435 572. 160Id. 161Id. at 581 (punctuation omitted). COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT "Congress 're-one of the most rights associated serves follow risk' rule to govern determinations with ownership in section 801."149 The statutory proLpyeornty n.1o5n6etheless claimed that building and that it was entitled to take depreciation in section 167.157 The Eighth Circuit, "reserves follows risk" rule] ... with government's anything, the language is a substantial obstacle to "the benefits, risks, and burdens the Government's position. Lyon] has with respect the Worthen "risk" does not occur.150 are simply too insubstantial to establish to the status of owner for tax purposes."158 the statute did not provide risk intensely factual basis invent one, that analysis of the parties' arrangements. The Court obrequirement was "logic [all.11151 served that it had decided Consumer in the way of formal legal title to shif the lower courts decide economic substance cases, Con-of sumer have signifi-property where the transferor continues to retain cant reduction motive, and it did risk significant control over the property over transthrough transactions. those factors alone ferred. this doctrine of substance the company favorable treat-Court has looked to the objective eco-ment the lower courts' free-floating test.152 How-nomic realities of the transaction rather than to the ever, the Court examined the applicable statutes and particular form the parties employed.159 applied Congress's intent, not its own, and could find suggest the legislature risk-shifting the absence tax-the Court tax benefits under sec-for purposes of section 167. tion 801. Lyon's Frank Lyon v. United States matter how the transactions could have been Although economic risk was irrelevant in Consumer it a as were placed in final obliga-that not it Con-tion ... fell squarely on Lyon. Lyon, an ongoing gress makes risk-taking a prerequisite to the enjoyment of enterprise, exposed its very business well-being to this real and substantial is illustrated by Frank Lyon v. United risk.160 153 because Lyon's "In Frank Lyon, the taxpayer entered into a sale-in building ... is Lyon that is entitled leaseback agreement with section 167."161 then a building out in more general terms: operate its banking business, but regulatory restrictions short, hold that where, as here, prevented it from doing so.154 The government regulators genuine multiple-party transaction with economic offer conditional approval of a sale-leaseback trans-which encouraged action, purchased suitable business or regulatory realities, is imbued with building and sold it piece by piece to Lyon as it was tax-independent considerations, and is not shaped On the building's solely by tax-avoidance features that have meanimmediately leased the building back to Worthen.155 ingless Government should parties' at the end of the lease. by the parties. Expressed another way, so long as could exercise that option simply by paying Lyon the the lessor retains significant and genuine attributes of the building when the lease was entered. Thus, event that the building appreciated, Worthen the building 156 did to exercise See id. at 571. Worthen also had various other at the property, which caused therefore positioned to enjoy the economic appreciation that Frank Lyon had "toted an empty and deductions section 167. Id. at 570-571 (quoting 536 F.2d 746, 751-753 (8th Cir. 1976)). 157Section 167 generally allows the owner of property depre-149150Id. at 740. ciation property's wear and tear. Id. 167(a) does not explicitly provide ownership require-151 See id. ment but one is implied by a fair reading of the statute. 152See, e.g., Coltec, supra Part ILA. 15 435 U.S. at 572 (citing 536 F.2d at 754). 153435 U.S. 561 (1978). 159435 U.S. at 572. 154See id. 1601d. at 577. 155See id. 161Id. 982 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.162 Lower courts have seized on the first sentence from to created freefloating economic substance doctrine.163 But it did no such thing. Although the Court did state that a transaction imbued with economic substance must be respected, that statement is simply part of the ownership test under section 167.164 In fact, in the very next sentence, the Court its pedestrian holding as a nominal lessor retains ‘‘genuine attributes of the traditional lessor status,’’ the form of the sale-leaseback will be respected.165 In a later decision, Nebraska Dept. of Revenue v. Loewenstein, a unanimous Court explicitly Frank Lyon’s holding to a statute that did not refer to ownership.166 Given that the Supreme Court itself refused to outside of hard to understand why lower courts think that case is relevant in every context. The Court’s refusal to apply a floating economic substance test in Loewenstein plainly indicates that statutory language must be examined whether and to apply economic substance principles, but the lower courts have somehow missed the message. E. Cottage Savings v. Commissioner In Cottage Savings v. Commissioner, the Court addressed whether a reciprocal sale of mortgages qualified as a sale or other disposition within the meaning of section 1001.167 Cottage Savings, a savings and loan association (S&L), held numerous long-term, low-interest mortgages that had declined in value when interest rates surged in the late 1970s.168 The company wished to sell those mortgages and thereby recognize a large tax loss, but the required record losses books. If Cottage Savings’ losses were reflected on its books, it could face closure by the agency. In 1980 the FHLBB relaxed its reporting requirements. The agency ruled that losses from a sale of mortgages need not be reported on an S&L’s books if those mortgages were exchanged for ‘‘substantially identical’’ mortgages held by other lenders.169 That ruling cleared the Cottage with lenders and thereby recognize a tax loss. To accomplish its desired tax result, Cottage Savings sold its interest in 250 mortgages to four other S&Ls. It 300 mortgages held by those S&Ls. The face value (and the basis) of the mortgages sold by Cottage Savings was $7 million, the the mortgages it had exchanged them for was $4.5 million. Cottage Savings thus claimed a tax loss of $2.5 million on account of its transaction with the other S&Ls. Section 1001 governed the tax treatment of Cottage Savings’ transaction. That section provides that to realize ‘‘or other disposition of [the] property.’’ Thus, even if by a taxpayer declines taxpayer a tax loss until ‘‘realization’’ event.170 Regulations issued under section 1001 stated that gain or loss is realized when a taxpayer converts its cash, exchanges its property materially different property.171 accordance with Court stated that Cottage Savings would realize a tax loss on its mortgages exchanged materially different from those which it received. The commissioner, however, argued that the ‘‘different’’ language contemplated an economic substance analysis. The Court rejected that argument: that ‘‘materially different’’ only if they differ in economic substance. To determine whether the participation in were ‘‘different’’ in this sense, the Commissioner argues, we should look to the attitudes of the parties, the evaluation of the interests by the secondary mortgage market, and the views of the FHLBB. We conclude that section 1001(a) embodies a much less demanding and less complex test.172 583-584. 163See Yoram Keinan, ‘‘The Many Faces of the Economic Substance’s Two-Prong Test: Time for Reconciliation?’’ 1 NYU J.L. & Bus. 371 (2005), for a discussion of the lower courts’ of Frank Lyon. 164435 583-584. 165Id. 584. 166See 513 U.S. 123, 133-134 (1994) (‘‘Respondent relies on our Lyon. . . . dispositive question whether the Trusts earned interest on ‘obligations of the United States Government,’ not whether the Trusts ‘owned’ such obligations. As respondent himself concedes, ‘‘the concept of ‘ownership’ is simply not an issue under [31 U.S.C. section 3124].’’) (emphasis added). In Lowenstein, the Court examined the economic realties of the taxpayer’s transaction in a manner consistent with statutory language. The statute at issue in that case protected interest on ‘‘obligations of the United States Government’’ from state taxation. See 31 U.S.C. section 3124. Thus, the Court examined the taxpayer’s transaction to determine whether the interest he received was in fact on account of an obligation of the U.S. government. But the Court did not disregard the statute in favor of an examination of the taxpayer’s business purposes or potential for profit, as the lower courts might have done. Rather, a unanimous Court acknowledged that the dispositive question was whether the amount the taxpayer received constituted ‘‘interest’’ within the meaning of the statute. See id. Because Frank Lyon focused on the issue of tax ownership, its holding simply was not relevant in Lowenstein. See id. Nonetheless, lower courts continue to believe that Frank creates a universal two-prong test to apply to transactions. See Keinan, supra note 163. 167499 rev’g 2d 1989). 168See id. at 556. 169See id. at 557. 170Section 1001(c) states that gain or loss realized under section 1001 must be recognized. 171See reg. section 1.1001-1. 172Id. 562. COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT the traditional lessor the the Cottage Savings, a savings and loan interest purposes.162 value when interest late 168 sell those sentence that passage to conclude that the Court created a free-Federal Home Loan Bank Board (FHLBB) generally refloating economic substance doctrine.163 no quired S&Ls to record losses from such sales on their did state that a transac-Cottage Savings' were refected tion with economic substance must be respected, could face closure by the agency. simply In fact, in the very next the Court the FHLBB relaxed its reporting expressed its pedestrian holding in another way: As long losses a sale of mortgages "L's morttraditional lessor status," the form of the sale-leaseback gages were exchanged for "substantially identical" mortwill be respected.165 gages other lenders.169 That ruling way for Cottage Savings to swap mortgages with other decision, Nebraska Dept. of Revenue v. Loewen-recognize loss. stein, a unanimous Court explicitly refused to apply Frank Lyon's holding that did owner-result, Cottage Savings ship.166 Supreme refused 250 to apply Frank Lyon outside of the ownership context, it is simultaneously purchased interests in lower courts think that case those The Court's to sold Cottage Savings was free-floating economic substance test in Loewenstein whereas the FMV of the mortgages it had exchanged indicates statutory language must be exam-was Cottage ined in determining whether and how to apply economic of $2.5 million on account of its transaction with principles, message. governed the Cottage Savings' a gain or loss on property, the taxpayer must effect a "sale v. Commissioner, the Court addressed other disposition property." a as a property held by a taxpayer declines in value, the taxor other disposition the meaning of section payer cannot recognize a tax loss until a "realization" 170 section 1001 loss property into cash, or when it exchanges its property for 162Id. at 583-584. materially different 163 property.171 See Yoram Keinan, "Manv Faces the Economic In accordance with the regulation, the Court stated Substance's Two-Prong Test: Time for Reconciliation?" would a L. Bus. for of courts' reciprocal sale if the mortgages it exchanged were ma-164 various interpretations of Frank Lyon. terially different from those which it received. The com-435 U.S. at 583-584. 165Id. at 584. missioner, however, argued that the "materially differ-166See 513 U.S. 123, 133-134 (1994) ("Respondent relies on our ent" language contemplated an economic substance statement in Frank Lyon... Lyon... But the dispositive question is interest on 'obligations The Commissioner argues that properties are "ma-Government,' not whether 'owned' respondent himself concedes, "the concept 'owner-terially different" if they differ in economic ship' simply an issue 3124].") To determine whether the participation Lowenstein, the Court eco-interests exchanged in this case were "materially nomic taxpayer's a manner consis-different" in this sense, the Commissioner argues, tent statutory language. The statute at issue that case the attitudes the parties, "the United States Govern-mortment" from state taxation. See 31 U.S.gage and the FHLBB. We examined taxpayer's transaction to determine section 1001(demanding and less complex U.But the Court not test.172 the in an examination taxpayer's purposes or potential for have 167499 U.S. 554 (1991), rev'g 890 F.2d 848 (6th Cir. 1989). constituted "interest" within 168See id. See id. Because Frank Lyon focused on the issue of 169See id. simply was not relevant in Lowenstein. 170Section that loss realized under id. Nonetheless, lower courts continue Frank Lyon creates a universal two-prong test to apply to all tax 171 See reg. See 163. 172Id. at 562. TAX NOTES, September 10, 2007 983 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315Nothing in the regulation’s ‘‘materially different’’ language that taxpayer’s or business purpose must be examined, and the Court refused to make those examinations. The Court flatly rejected the commissioner’s ‘‘exchanges must satisfy a subjective test to trigger realization of a gain or loss.’’173 Instead, the Court found that that so long as the properties exchanged embodied legally distinct entitlements,174 they would be considered materially different, and concluded that Cottage Savings’ transaction easily satisfied that test. The Court further rejected the argument that the taxpayer’s losses were not real, disagreeing with the commissioner that the taxpayer’s loss somehow ‘‘lacked ‘economic substance.’’’175 Although the Court clearly relied on statutory language reaching its decision, Cottage is often viewed as an exception to the economic substance doctrine.176 One court has even rejected the Court’s ‘‘less complex and less demanding’’ interpretation of section 1001 and has held that the economic substance doctrine continues to float over that statute.177 One prominent that the Court erred, saying that in Cottage Savings: the Supreme Court ignored the economic substance argument altogether and focused almost entirely on the obvious point that the losses were realized under section 1001. Even the dissent seems to have missed the point, arguing that the losses were not realized under section 1001.178 Those comments aside, the Supreme Court did not miss anything. It had no reason to address a free-floating doctrine it created the approach: and applied to the facts in front of it. There is no doubt that the Court’s analysis in Cottage is different from in the Court’s cases. In Cottage Savings, the Court did not examine whether the taxpayer had a business purpose or whether the reciprocal sale appreciably affected the taxpayer’s beneficial interest. But the Court’s seemingly narrow the governing statute. Section 1001, reasonably interpreted, is not limited to only those transactions in which a taxpayer exchanges a business which he expects to profit. If a taxpayer, solely for tax reasons, goes to an automobile dealer and exchanges his car for $5,000 or for a different car, he has no less sold or disposed of the car than if he had done so with a business with a profit expectation. Indeed, Cottage Savings involved a mundane transaction, and there was no reason for the lower courts (much less the Supreme Court) to go beyond the ‘‘materially different’’ language in determining whether the taxpayer could recognize a Savings’ economic substance demonstrates that the doctrine has gone too far. Although economic substance analysis was misplaced in Cottage Savings, that does not mean that it is always misplaced. Cottage Savings does not foreclose all economic substance inquiries. Rather, it indicates that courts should not make those inquires unless a fair interpretation of the governing statute makes those inquiries Congress motive a prerequisite the enjoyment of tax benefits. F. Portland Golf v. Commissioner In Portland Golf v. Commissioner, the Court addressed whether the taxpayer’s absence of a profit motive prevented it from enjoying deductions under section 162.179 Portland section 7), operated a private country club. Although gains and losses from a section 501(c)(7) organization’s social activities are generally ignored in calculating its taxable income, gains and losses from nonsocial activities must be calculated separately and are not exempt from tax. Portland Golf engaged in activities unrelated to its tax-exempt social — it sold food at its club and also made various financial investments. suffered losses food sales use to offset gains it its investments. The taxpayer claimed a loss on account of the food sales under section 162(a), which provides a ‘‘all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.’’ The commissioner did not allow that loss, finding that losses deducted under section 162 must relate to a taxpayer’s for-profit activities, and that not sell Golf countered that section 162 did not impose a profitmotive under that statute — it had unquestionably lost money from its sales. It argued alternatively that even if section 162 imposed a profit motive requirement, it did seek profits from its food sales. able to deduct losses from its food sales if those losses 173Id. 565. 174Id. 566. 175Id. 567-568. 176See infra notes 194-198. 177See ACM, 157 F.3d at 251. (‘‘ACM Tax Court was bound to respect the tax consequences of ACM’s exchange of Citicorp notes for LIBOR notes because, under Sav. Ass’n v. Commissioner, an exchange of property ‘materially different’ assets is a substantive disposition whose tax effects must be recognized. We find Cottage Savings inapposite.’’) Judge McKee, writing in dissent, criticized the majority for ignoring Cottage Savings. See id. at 263. (‘‘that ACM’s sales of the Citicorp notes for cash and LIBOR Notes ‘satisfied each requirement of the contingent installment sales provisions and the ratable basis recovery rule,’ yet, simultaneously subjecting these transactions to an economic substance and sham transaction analysis, the majority has ignored the plain language of IRC section 1001, and controlling Supreme Court precedent. We have injected the ‘economic substance’ analysis into an inquiry where it does not belong.’’) 178Hariton, supra note 9, at 256. 179497 1990). COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT regulation's "different" lan-But Court's seemingly guage suggested that the taxpayer's attitude or business analysis is easily explained by the governing statute. refused 1001, reasonably interpreted, is not limited The Court rejected those transactions which a taxpayer exchanges commissioner's contention that "exchanges of properties property with a business purpose or in a transaction in test to to a taxpayer, loss."173 Instead, the Court found to an automobile exchanges or car, entitlements,174 would be considered materially a concluded that Cottage Savings' transac-purpose or with a profit expectation. Indeed, Cottage tion easily rejected involved the taxpayer's losses real, courts (much less the Supreme with commissioner the taxpayer's "different" language loss somehow "lacked 'economic substance."'175 determining whether the taxpayer could recognize clearly statutory lan-loss. That Cottage Savings' simple mortgage swap was guage in reaching its decision, Cottage Savings is ofen even a candidate for economic substance analysis demviewed as only an exception to the economic substance onstrates has 176 One court has even rejected the Court's "less economic substance demanding" section Cottage Savings, that does not mean that it and held Savings does not ecocontinues to float over that statute.177 One prominent nomic commentator suggests that the Court simply erred, say-interpretaing that in Cottage Savings: tion of the governing statute makes those inquiries the economic substance relevant. Indeed, Congress remains free to enact a statute that makes a profit motive a prerequisite to the enjoythe that the losses were realized ment benefits. section 1001. E Portland Golf v. Commissioner the losses Portland Golf v. Commissioner, the realized under section 1001.178 taxpayer's of a profit pre-aside, the Supreme Court did vented it from enjoying deductions under section 162.179 had no reason floating In that case, Portland Golf, an organization exempt from economic substance doctrine because it never created tax under section 501(c)(7), operated a private golf and that doctrine. Instead, the Court followed its usual ap-gains and losses a section proach: It examined the governing statute and applied it 7) organization's are generally in calculating its taxable income, gains and losses the Court's analysis in Cottage nonsocial activities must be calculated separately Savings is different from that seen in the Court's previous engaged In Savings, the Court did examine two activities unrelated to its tax-exempt social purposes -it sold food at its club and also made reciprocal sale affected taxpayer's Portland Golf suffered losses from its food sales and wished to use those losses to offset gains it enjoyed from account 173Id. at 565. sales a), which 174Id. at 566. deduction for "all the ordinary and necessary expenses 175Id. at 567-568. the taxable 176177See infra 194-business." commissioner did not See ACM, 157 F.3d at 251. ("ACM contends that the Tax that losses deducted under section 162 bound to respect the tax consequences ACM's taxpayer's of notes LIBOR notes because, Portland Golf did not sell food to make a profit. Portland Cottage Sav. Assn v. Commissioner, an exchange of property for 'different' assets whose did profittax We Cottage inappo-motive requirement and that it was entitled to deductions site.") McKee, writing -it had unquestionably lost money ignoring Cottage Savings. See ("By finding that sales. section ACM's sales notes cash LIBOR Notes imposed a profit seek 'installment sales its food sales. ratable rule,' vet, simulta-The Court acknowledged that Portland Golf would be neously these an economic substance losses food sales if those losses the language IRC section 1001, Supreme precedent. injected the 'economic substance' into does belong.") 178Hariton, supra note 9, at 256. 179497 U.S. 154 (1990). 984 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315were described in section 162. However, the Court agreed with the commissioner that the statute required a profit motive as a prerequisite to the enjoyment of its benefits. case, Groetzinger, the Court observed that statutory term ‘‘business,’’ commonly understood, is ‘‘that which occupies the time, attention and labor of men for the purpose of a livelihood or profit.’’180 Thus, the Court found that a profit motive was implicit in section 162’s reference to the carrying on of a business.181 The Court then examined whether Portland Golf was motivated by profit in selling food at the club. Although the Court found that the taxpayer had suffered losses from its food sales, that fact did ‘‘not, by itself, prove that Portland Golf lacked a profit motive.’’182 Nonetheless, the Court found that the taxpayer ‘‘failed to show that it earn excess of its total . . . costs’’183 and consequently held in favor of the commissioner. Portland Golf casts doubt on the lower courts’ interpretation Gregory. If and its progeny ‘‘mere compliance with the Code provisions resulting in will be sanctioned when there is, independent of the tax consequences, business or corporate purpose,’’184 and that the economic to any Code provision allowing deductions,’’185 then much of the Court’s statutory analysis Portland Golf (and in Groetzinger) superfluous. The Court would not have had to perform a careful parsing of section 162’s language and a thorough examination of the statute’s history to conclude that it motive. Rather, if Gregory imposes requirement onto all statutes deductions, the Court would have stated that the ‘‘carrying on of a trade or business’’ language in section 162 is irrelevant— floating purpose test would regardless of what Congress said. But unlike the lower courts, the Supreme Court examined the statutory language and principles consistent with that language, not in contravention of it. Landreth Timber Because it is not only tax statutes that contain economic examine economic substance principles whenever a statute makes those principles relevant, regardless of where it is codified. For example, in Landreth Timber Co. v. Landreth,186 the Court interpreted the term ‘‘stock’’ as it found in section 2(1) of the Securities Act of 1933.187 Landreth Timber Co. had purchased stock from Landreth and argued that Landreth had made misrepresentations regarding the stock in violation of the securities act. Landreth countered that although the instrument he sold was labeled stock, an analysis of the economic substance of the instrument would indicate that it did not fit that description, and the securities act could not therefore apply to his sale.188 The Court acknowledged that it had ‘‘decided a number of cases in which it looked to the economic substance of the transaction, rather than just to its form, to determine whether [the securities act] applied.’’189 The Court discussed its prior decision in SEC v. W.J. Howey, in which it held that an unusual instrument constituted a security within the meaning of the securities act ‘‘because, looking at the economic realities, the transaction ‘involve[d] an enterprise with to come solely from the efforts of others.’’’190 According to the Court, mere labels cannot determine whether a financial instrument falls within the purview of the securities laws.191 Rather, the economic substance of an instrument must be examined. The Court proceeded to examine the ‘‘stock’’ at issue in Landreth Timber and concluded that it was what it was purported to be, finding in favor of the petitioner. Although the Court examined economic substance Landreth it create freefloating doctrine. The application of economic substance principles was grounded in the statute. The term ‘‘stock,’’ in the context of the securities act, describes financial instruments bearing specific economic characteristics,192 and not simply any instrument that is labeled as such. But the Court did not examine whether the seller had a ‘‘securities act avoidance’’ motive in structuring his sale because a fair interpretation of the statute did not make that examination relevant. And the Court did not state that ‘‘mere compliance’’ with the securities act is insufficient to obtain an exemption under the statute. Landreth is consistent with Gregory, Knetsch, Consumer Life, Frank Lyon, Cottage Savings, and Portland 180Commissioner v. 480 U.v. Stone Tracy Co., S. supplied). 181See also 497 U.S. at 173 (Kennedy, J., concurring). (‘‘Although [section 162(a)] does not require a profit motivation by its express terms, we have inferred such a requirement because the words ‘trade or business,’ in their ordinary usage, contemplate activities undertaken to earn a profit.’’) 183Id. 184Stauffer’s Estate, 403 F.611. 185Wexler, 186471 1985). 18715 C.A. 77b(188471 U.S. at 688. If the instrument was not in fact stock, Landreth Timber Co. would not have been able to seek relief under the securities act. 189Id. 190Id. at W.J. Howey Co., S. 1946)). 191See id. at 688. (‘‘Respondents are correct that in Forman we eschewed a ‘literal’ approach that would invoke the Acts’ coverage simply because the instrument carried the label ‘stock.’’’) 192See id. at 686. (‘‘We identified those characteristics usually associated with common stock as (i) the right to receive dividends negotiability; (iii) the ability to be pledged or hypothecated; (iv) the conferring of voting rights in proportion to the number of shares value.’’) COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT However, 1933.187 Landreth Timber Co. had purwith the commissioner chased stock from benefits. made misrepresentations regarding the In an earlier case, GroetLinger, the Court observed that the of the securities act. Landreth countered "business," commonly understood, he sold was labeled stock, "occupies economic of instrument the purpose a livelihood or proft."180 Thus, indicate not fit that description, in section securities act could not therefore apply to his sale.188 162's reference to the carrying on of a business.181 "num-ber in which to the economic substance selling found that the taxpayer had suffered losses than deter-that fact did "mine [the securities act] applied."189 lacked a motive."182 decision in SEC WJ. in which "that an constituted intended to earn gross income from nonmember sales in the meaning of the securities "because, looking excess of its total ... costs"183 and consequently held in 'the commissioner. investment of money in a common enterprise with profits the efforts of others."'190 Golf casts doubt on the lower courts' interpre-the Court, mere labels cannot tation of Gregory. If Gregory and its progeny indicate that "with instrument falls within the securities laws.191 a tax advantage will be sanctioned by the courts only there is, independent of the tax consequences, must be examined. proceeded purpose,"184 and "stock" at issue in Landreth Timber and substance doctrine is a prerequisite to any Code provision that it was purported to be, deductions,"185 then much of Court's statu-favor of the petitioner. tory analysis in Portland Golf (and in Groet-inger) is the Court examined economic substance principles in Landreth Timber, it did not create a freecareful 162'thorough floating doctrine. The application of economic substance of statute's history term "stock," required a profit motive. Rather, if Gregory imposes a profit requirement onto all statutes offering deductions, the context of the securities act, describes instruments bearing specific economic characteristics,192 have "business" language in section 162 is irrelevant -any instrument that is labeled as such. a free-floating business purpose test would apply regard-not examine whether the seller less said. But unlike "avoidance" his sale a fair interpretation applied economic substance principles in a manner con-And not state sistent "mere compliance" the securities an exemption under the statute. Landreth G. Landreth Timber Company v. Landreth Timber is thus entirely consistent with Gregory, Knetsch, it is tax statutes that contain contain eco-Life, and nomic terms, the Court will examine economic substance statute makes those principles of For example, in Landreth Timber Co. v. Landreth,186 the Court itnhtee rtperermte d"stock" found in section the 18715 U.S.C.A. section 77b(a)(1). 188471 U.S. at 688. If the fact stock, not have been able seek the securities act. 180Commissioner v. Groetzinger, 480 U.S. 23, 28 (1987) (quoting 180id. Flint v. Stone Tracy Co., 220 U.S. 107, 171 (1911)) (emphasis 1901d. at 689 (quoting SEC v. WJ. Howey Co., 328 U.S. 293, 301 sup lied). (1946?). 1See ("Al-19 See id. at 688. ("Respondents are correct that though a)] does not require a profit motivation a 'literal' that Acts' such a because simply the label 'business,' ordinary usage, contem-'stock."') plate profit.") 192See id. at 686. ("We identified characteristics usually 182Id. at 171 n.22. with common stock as (i) the right divi-183Id. at 171. dends contingent upon an apportionment of profits; (ii) nego-184185Staufer's Estate, 403 F.2d 611. tiability; (iii) the ability to be pledged or hypothecated; Wexler, 31 F.3d 127. in proportion to the number of shares 186471 U.S. 681 (1985). owned; and (v) the capacity to appreciate in value.") TAX NOTES, September 10, 2007 985 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315Golf. In each, the Court applied economic substance principles to the extent the statute demanded, and no more.193 H. Summary Gregory, Knetsch, Consumer Life, Frank Lyon, Cottage Portland Golf, and demonstrate that as little) economic substance as Congress’s statutes implicitly or explicitly require. Sometimes, as in Consumer Life, the applicable statute indicates that economic risk is irrelevant. At other times, as in Frank Lyon, the applicable statute indicates that economic risk should be the central focus of the Sometimes, Gregory Golf, regarding a taxpayer’s motives are relevant, but at other times, as in Cottage the statute makes those inquiries irrelevant. can argue that the Court erred in determining how much substance each statute required. Nevertheless, it is clear that the Court’s application of economic substance principles stemmed from its analysis of the governing statutes and not from a free-floating doctrine. That Gregory has long been invoked to ignore tax statutes may make one hesitant to accept this conclusion. But even if one believes that the interpretation of Gregory offered here is unduly narrow, the Court’s subsequent cases indicate that the Court itself has adopted a similar interpretation. In none of those cases—including Knetsch — did the Court apply the method seen in Compaq and fail to cite the statutes implicated by a taxpayer’s transaction. Nor did the Court ever use the Coltec approach and hold that a taxpayer qualified under the applicable statutes but then deny it the benefits regardless. And the Court never dismissed statutory analysis as a mere did in In re CM Holdings. Only in Consumer Life did the Court even entertain the argument that the absence of a business purpose might itself invalidate a transaction, but even in that case, the Court swiftly rejected the government’s contentions and on statutes in the One can offer various explanations for the Court’s continued refusals to ignore statutory language. Perhaps the Court overlooks the economic substance doctrine;194 perhaps the Court creates special exceptions to the doctrine;195 perhaps the Court makes a ‘‘political decision’’ sometimes ignore the doctrine;196 perhaps the Court selectively employs the doctrine;197 or perhaps the Court does not apply the doctrine when it feels sorry for a taxpayer.But the simplest explanation is the best one. page in Gregory, Court the radical step of stating that the legislature’s enactments should be tossed aside in favor of judicial tests. The statute-focused approach seen in the Court’s subsequent cases confirms this common-sense conclusion. Recommended A. Extent of Substance While the facts in the economic substance cases are complex, the difference between the lower courts’ approach Court’s illustrated by a simple example. Suppose Congress enacts receive a motivated solely by the statutory benefit, transfers to a third person some (but not all) rights in a piece of statutory benefit, the Supreme Court would likely examine whether the purported transfer constituted an actual in interpreting statute the Court ‘‘look[s] to the ‘ordinary, everyday senses’ of the words,’’199 and because the word ‘‘disposition’’ ordinarily a relinquishment of significant rights property,200 likely examine whether sufficient rights had in fact been relinquished.201 That is all the substance that the statute requires and all that would demand.202 193See also Florida v. Long, 487 U.S. 223, 235 (1988) (examining economic substance of pension plan to determine whether it violated the sex discrimination prohibitions of Title VII of the Civil Rights Act of 1964), and Copperweld Corp. v. Independence Corp., 467 U.752, 792-793 (1984) (Stevens, J., dissenting) of determine whether it constituted ‘‘combination or conspiracy in restraint of trade’’ within the meaning of the Sherman Act). 194See Hariton, supra note 9, at 256. 195See Gerald W. Miller Jr., ‘‘Corporate Tax Shelters and Economic Substance: An Analysis of the Problem and Its Law Solution,’’ 34 Tex. Tech L. Rev. 1015, 1060 (2003). (‘‘It becomes clear that Cottage Savings should probably stand for the proposition that the economic substance doctrine does not to non-economic transactions in taxpayer’s ordinary course of business that are within the statutory ambit.’’) 196See Lee A. Sheppard, ‘‘Corporate Shelters: A Snowball’s Chance of Pretax Profit,’’ Tax Notes, Aug. 7, 2000, p. 728, Doc 2000 TNT 152-3. (Cottage Savings’ transaction ‘‘no discernable economic substance and no raison d’etre other than the recognition of losses for tax purposes. So what? The Supreme Court made a political decision to let the struggling savings and loan industry help itself to yet more taxpayer funds. The Cottage Savings decision should be limited to its facts; it has no broader application than the Bob Jones University decision.’’) 197See 3d (‘‘see the existence of other Supreme Court cases that do not rely on the doctrine undermine the authority of those that do.’’) 198See Hariton, supra note 9, at 257. (‘‘We may draw from [Cottage Savings] the somewhat obvious conclusion that no tax result will be disallowed for lack of economic substance if the court has sympathy for that result.’’) 199Commissioner v. Soliman, 506 U.S. 168, 174 (1993) (quoting v. Riddell, 383 U.S. 569, 571 quoting Crane v. Commissioner, 331 U.S. 1, 6 (1947))). 200See Black’s Law Dictionary (8th ed. 2004) (defining disposition as the ‘‘the relinquishing of property’’). 201Cf. Cottage Savings, supra Part III.E. See also id. at 568 (discussing Higgins v. Smith, 308 U.S. 473 (1939), in which the Court ‘‘held that a taxpayer did not sustain a loss by selling securities below cost to a corporation in which he was the sole shareholder’’ and in which ‘‘losses were not bona fide because COMMENTARY /continued next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT each, the Court applied economic substance the doctrine;196 the extent the statute demanded, the doctrine;197 or perhaps the more.193 not 198 But the simplest explanation Summary In its two-page opinion in Gregory, the Court did not take Life, Lyon, Cottage stating that the legislature's enact-Savings, Portland Golf and Landreth demonstrate that the ments in judicial tests. Court demands only as much (or as little) economic in Court's subsesubstance as Congress's statutes implicitly or quent confirms common-sense Consumer risk irrelevant. IV. Recommended Approach Frank risk Extent of Substance inquiry. Sometimes, as in Gregory or Portland Golf the the facts in the economic substance cases are statute indicates that inquiries regarding a taxpayer's the courts' apmotives at other times, as in Cottage proach and the Supreme Court's approach can be illus-Savings, the statute makes those inquiries irrelevant. One trated by a simple example. Suppose Congress enacts a argue that the Court erred in determining statute stating that taxpayers will receive a tax benefit on each statute required. a disposition of property. Suppose further that a taxpayer, Court's of economic prin-statutory benefit, ciples from stat-person some a piece utes property. has long been invoked To determine whether the taxpayer qualifies for the Court would exam-of Gregory ine transfer constituted an narrow, the Court's subsequent disposition. Because in interpreting a tax statute the indicate that the Court "look[s] to the 'ordinary, everyday senses' In none cases -including Knetsch words,"199 and because the word "disposition" ordinarily -did the Court apply the method seen in Compaq connotes a relinquishment of significant rights in propfail to cite the statutes a taxpayer's trans-erty,200 the Court would likely examine whether suffiaction. did the Court ever use the Coltec approach cient rights had in fact been relinquished.201 That is under the applicable saull bthsteance that the statute requires and all that the Court the would never dismissed mere demand.202 formality, as the Third Circuit did in In re CM Holdings. in Consumer Life did the absence purpose apply to non-economic transactions encountered in the taxitself a transaction, even that case, payer's course that are within rejected the government's ambit.") focused on the applicable statutes in holding for the 196See Lee A. Sheppard, "Snowball's taxpayer. Profit," Tax Notes, 7, 2000, p. 728, Doc 2000-20826, 2000 TNT 152-3. (Cottage Savings' transaction "had Court's and no d'etre language. Perhaps of losses tax purposes. So the Court overlooks the economic substance doctrine;'94 Court a political to creates doc-trine;195 perhaps the Court makes a "political decision" to Savings decision should be limited application than the Bob Jones University decision.") 197See Coltec, 454 F.3d at 1353. ("We fail to see how the of Court that do not do.") 193See also Florida v. Long, 487 U.S. 223, 235 (1988) (examining 198See Hariton, 257. ("substance of pension plan to Savings] the somewhat obvious conclusion that discrimination prohibitions of be disallowed for lack of economic substance Rights Act of 1964), and Copperweld Corp. v. Independence result.") Tube Corp., 467 U.S. 752, 792-793 (1984) (Stevens, J., dissenting) 199Commissioner S. (examining economic substance of corporate arrangement to Malat v. Riddell, 383 U.S. 569, 571 (1966) (per curiam) (in turn "trade" the meaning of the Sherman 2ooSee Black's Law Dictionary (8th ed. 2004) (defining disposi-194See Hariton, 256. tion "property"). 195See Gerald W. Jr., "Corporate Tax Shelters 201 Cf. supra Part See Substance: An Analysis of the (1939), in which Common Law Solution," 34 Tex. Tech L. Rev. 1015, 1060 (2003). "held that a taxpayer not sustain a loss selling ("becomes Savings should probably to he was that the economic substance shareholder" which "losses were not bona fide because (Footnote continued in next column.) (Footnote continued on next page.) 986 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315A lower court, contrarily, might not even examine Rather, the mere fact that the taxpayer was motivated solely by tax incentives might be sufficient to prevent her from enjoying the statutory benefit.203 Alternatively, a lower court might examine the transaction and agree that a disposition within the meaning of the statute had been but ‘‘compliance’’ the code insufficient and deny her statutory benefits regardless.204 even impose penalties the taxpayer, despite the statute.205 If were facing criminal charges, the court might instruct the jury that compliance with a statute is insufficient to escape conviction.206 approaches interpretation are completely different. If a taxpayer has complied with a statute, the Court’s inquiry ends. The Court has never said that it will disregard a transaction that has ‘‘complied each and every of the relevant requirements imposed by the Code.’’207 The lower courts, contrarily, apply economic substance principles regardless of what The Supreme Court should instruct the lower courts to economic principles only extent that a fair interpretation of the applicable statute makes those principles relevant. This would bring tax law closer to other areas of federal law, in which it would be unthinkable for a court to disregard a citizen’s mere with Further, judicial resources would conserved in cases like Compaq, in which the commissioner stipulates that the taxpayer has complied with all statutory requirements.If the lower courts recognize that ‘‘mere compliance’’ with a statute is enough, there will be no reason to waste time addressing arguments based One might nonetheless question whether requiring courts to apply statutory language will make a difference in the outcomes of cases. Perhaps, even if lower courts are restricted to the statute, they will just bend over backwards to find against taxpayers. Similarly, in criminal perhaps defendants will regardless of jury instructions. Perhaps the distinctions discussed here reflect nothing semantics. But ‘‘the practice of tax law is fundamentally the practice of statutory interpretation,’’210 and debates lie that practice. The Tax Court has even been reversed for misinterpreting the word ‘‘the.’’211 language make a Life, for the Supreme Court reversed the Fifth Circuit after the lower court had used a ‘‘judicial overlay’’ to impose requirements that were nowhere to be found in the governing statute.212 In Coltec and Compaq, the Federal Circuit and Tax Court could find nothing in the applicable statutes that would deny the taxpayers their claimed benefits.213 Surely those cases would have been decided differently had the courts followed the Supreme Court’s Wexler, the government expressly stated that it would have a harder time prosecuting individuals if it could not invoke a judicial doctrine — the doctrine does make a difference in criminal cases. And in Horn, the D.C. Circuit a result entirely reached courts that had applied a free-floating doctrine.214 The noted that the taxpayer’s transaction lacked economic substance, but it analyzed section the transaction was not conducted at arm’s length and because 108 of the Deficit Reduction Act ‘‘to see whether it the taxpayer retained the benefit of the securities through his wholly owned corporation’’). 202See, e.g., Commissioner v. Brown, 380 U.S. 563, 570 (1965). (‘‘To say that there is no sale because there is no riskshifting . . . has rationality but it places an unwarranted construction on the term ‘sale.’ . . . We reject it.’’) 203See, e.g., Coltec, 454 F.3d at 1355. (‘‘The doctrine may well also apply if the taxpayer’s sole subjective motivation is tax avoidance even if the transaction has economic substance.’’) 204See also Donald L. Korb, ‘‘Korb Gives Speech on Economic Doctrine,’’ Doc 2005-1540, 16-22 (Jan. 25, 2005). (‘‘It is not enough for a transaction to have merely occurred. The transaction must have appreciably changed the taxpayer’s net economic position before it will be given effect for purposes.’’) 205See Compaq, supra Part II.C. 206See Wexler, supra Part II.D. 207Heinz, at 591. 208That lower courts freely disregard tax statutes (but usually pay heed to nontax statutes) may be due to a phenomenon aptly described as tax myopia. See Paul L. Caron, ‘‘Tax Myopia, or Mamas Don’t Let Your Babies Grow Up to Be Tax Lawyers,’’ 13 Va. Tax Rev. 517, 518 (1994). (‘‘Tax law too often is mistakenly viewed by lawyers, judges, and law professors as a selfcontained body of law . . . this misperception has impaired the development of tax law by shielding it from other areas of law that should inform the tax debate.’’) 209See supra Part II.C. 210Brian Galle, ‘‘Interpretative Theory and Tax Shelter Regulation,’’ 26 Va. Tax Rev. 357, 358 (2006). 211See The Limited, Inc. v. Commissioner, 286 F.3d 324, 333 Doc 8860, 2002 71-10 (6th Cir. 2002), rev’g 113 T.C. 169, 29280, 1999 TNT 173-5 (1999). (‘‘Rather than conduct above plain-language analysis, the Tax Court focused on the term ‘the’ in the phrase ‘the banking business.’ Reading meaning into a definite article has been rejected by at least one other circuit and it is hardly the wisest place to begin statutory interpretation.’’) 212See supra Part II.C. See also First R.R. & Banking Co. of v. United 514 F.2d 675 (5th J., dissenting). (‘‘Had Congress desired to define a life insurance company in terms of the ultimate risk, it could have easily done so. The judicial overlay to that effect is an unnecessary intrusion into the legislative process. Reserves being the lodestar, they should control.’’) First R.R. was consolidated with two other cases after the taxpayer filed a petition for a writ of certiorari and was reversed by the Supreme Court in Consumer Life. 213See supra Part II.A and II.C. 214See 968 F.2d at 1234. (‘‘Although the result in this case seems straightforward to us, our judgment is offered with some trepidation in light of the contrary conclusions reached by three sister circuits, the Tax Court and the Commissioner.’’) COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT lower court, contrarily, might not even examine "compliance" a statute will whether the taxpayer relinquished rights in the property. reason waste time addressing arguments based the fact solely on a free-floating doctrine. enjoying the statutory benefit.203 nonetheless might examine the transaction and agree make a the meaning of the statute had been the outcomes cases. even if effected, but deem "mere compliance" with the code to they will just bend over insufficient and deny her statutory benefits regardless 204 against Similarly, in crimi-The court might even impose penalties on the taxpayer, nal cases, perhaps defendants will be convicted regarddespite her compliance with the statute.205 If the taxpayer less instructions. Perhaps diswere the court might cussed here reflect nothing more than a petty debate over that compliance a statute insufficient But "of tax law escape conviction.206 statutory interpretation,"210 and debates over semantics lie at the heart of that practice. The Tax The two approaches to statutory interpretation are has word "the."211 Court's ends. The Court has never will disregard a transaction has "com-An examination of statutory language (rather than the plied with each and every of the relevant requirements application of a doctrine) will make a difference in many the Code."207 The lower economic substance cases. In Consumer Life, for example, economic principles of Court reversed the Fifh Circuit afer the Congress says. "judicial overlay" to impose Court should that were nowhere to be found the governing statute.212 In Coltec and Compaq, the Federal apply economic substance principles only to the extent interpretation of the applicable statute makes Court find appli-would cable that deny the taxpayers their claimed benefits.213 Surely those cases would have been other of law, in would be had the Supreme court to disregard a citizen's mere Court's approach and observed statutory language. In compliance with a statute, or imprison her despite that compliance.208 Further, judicial resources would be con-the government expressly stated that it served cases in which harder time prosecuting individuals complied with statu--the doctrine does make cases. And Circuit tory requirements.209 If the lower reached a result entirely different from that reached by courts that had applied a free-foating doctrine.214 The D.C. Circuit explicitly noted that the taxpayer's transaction lacked economic but analyzed section arm's length and because the Deficit Reduction "see owned corporation"). 202See, e.g., Commissioner v. Brown, (1965). ("there is no sale because is riskshifting ... but it places an unwarranted con-210Brian "Theory and Tax Shelter Regustruction 'safe.'. . it.") lation," 26 Va. Tax Rev. 357, 358 (2006). 203See, e.g., Coltec, 454 3d ("211See The Limited, the taxpayer's sole 2002-8860,2002 TNT 71-10 (6th Cir. 2002), rev'g 113 T.C. 169, Doc transaction has economic substance.") 1999-29280, 1999 TNT 173-5 (1999). ("Rather than conduct the 204See also Donald L. Korb, "the Substance Doctrine," Doc 2005-1540, 2005 TNT 16-22 (Jan. 25, 'the' in the phrase 'the banking business.' Reading mean-("is not enough for a transaction to have merely ing a definite article has been rejected is hardly the wisest place to begin statutory taxpayer's position it interpretation.") tax urposes.") 2 See supra Part II.also First R.R. & 5See Compaq, supra Part Georgia v. United States, 514 F.2d 675 (5th Cir. 1975) (Roney, J., 206See Wexler, supra Part ILD. ("Congress insurance 207Heinz, 76 Fed. Cl. at 591. could have 208That (but usually judicial intrusion due phenomenon aptly the legislative process. Reserves tax Paul L. Caron, "Myopia, control.") with other Don't Your Babies to Be Lawyers," after the taxpayer filed a petition for a writ 1994). ("the Supreme Court in Consumer Life. lawyers, judges, law professors self-213See supra Part ILA contained body ... this misperception has 214See 968 2d ("the result in this case from other areas straightforward some the tax debate.") in light of the contrary conclusions reached 209See supra Part Commissioner.") TAX NOTES, September 10, 2007 987 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315nonetheless authorize[d] the claimed deductions,’’215 finding in favor of the taxpayer. Other circuits simply refused to undertake that analysis and reached the opposite result, stating that ‘‘section 108 does not even come into play.’’216 The debate over whether courts should apply a statute’s terms rather than a judicial doctrine is not frivolous.217 Language does make a difference. ‘‘The entire concept of written law, indeed of all verbal communication, depends on the idea that words have some meaning,’’218 and statutory language, if observed, does place an ‘‘objective constraint on [a judge’s] conduct.’’219 some of applying than a judicial doctrine) will not make a substantive difference. In those cases, a judicial doctrine would merely ‘‘the pains of reasoning,’’220 and if a court undertakes the pains of statutory analysis, it will find against the taxpayer.221 For example, claimed tax benefits regarding the worst variants of so-called LILO transactions can be denied not because those transactions fail a judge-made test, but simply because circular transfers of funds and rights do not genuine, distinct and should See 2002-760, But even when a court would rule against the taxpayer anyway, the application of the economic substance doctrine is inappropriate. Stating that claimed tax benefits are unavailable due to the judiciary’s inventions rather than Congress’s statutes leaves one wondering whether the court has simply applied a ‘‘smell test.’’222 Such tests to further the integrity of the legal system should be discarded. matter, conclusory judicial tests are required to prevent taxpayers from manipulating the code.223 taxpayer’s meaningless labels should never govern the interpretation of those provisions, even in the absence of arbitrary, judicially created doctrines.224 Substance should always form when Congress enacts provision. For example, if, to secure a tax benefit granted to a sells property binding, prearranged plan, buys it back 10 seconds later for $100, it does not matter that she literally sold the language must be fair, ordinary meaning,225 not its strict, literal meaning,226 and 215Id. at 1238. (‘‘While following the parties’ assumptions that the transactions at issue here were not entered into for economic profit and that no evidence has shown a nontax business purpose, we analyze section 108 to see whether it nonetheless authorizes the claimed deductions.’’) 216See Lerman, 939 F.2d at 52. (‘‘Because [these transactions] are not recognized for tax purposes, section 108 does not even into play.’’) 217See also Robert Thornton Smith, ‘‘Business Purpose: The Assault Upon the Citadel,’’ 53 Tax Law. 1, 33 (1999). (‘‘There is no topic more central to the integrity of the tax law than an appropriate theory of statutory interpretation for the Code.’’) 218Simpson United States, Cir. (Arnold, J.). Judge Arnold continued, ‘‘It is true that the ingenuity of lawyers can usually scrape up some tag end of ambiguity on which to hang a policy hat. But judges are obliged, unless there is a substantial uncertainty as to the meaning of the words of a statute, to apply the statute as written, unless the words are simply nonsense, or self-contradictory, or something kind.’’ Id. 219Hon. Alex Kozinski, ‘‘What I Ate for Breakfast and Other Mysteries of Judicial Decision Making,’’ 26 Loy. L.A. L. Rev. 993, 996 (1993). (‘‘Language has meaning. This doesn’t mean every word is as precisely defined as every other word, or that words always have a single, immutable meaning. What it does mean is that language used in statutes, regulations, contracts and the Constitution place an objective constraint on our conduct.’’) 220Commissioner v. Sansome, 60 F.2d 931, 933 (2d Cir. 1932) (Hand, J.). 221See, e.g., Dean Weiner and Christopher W. Campbell, ‘‘Right Results? Wrong Theories! — Coltec Industries and Castle Harbour,’’ 34 Corp. Tax’n 12 (2007) (suggesting that two tax could have been decided in favor government without resort to a free-floating doctrine); Glassman, supra note 9, at 710 (examining five types of tax shelter transactions and concluding that only two ‘‘would have been allowed in a world without the economic substance doctrine’’). 222See ACM, 157 F.3d at 265 (McKee, J., dissenting) (‘‘I can’t help but suspect that the majority’s conclusion [is] something akin to a ‘smell test.’ If the scheme in question smells bad, the intent to avoid taxes defines the result as we do not want the taxpayer ‘put one over.’’’). 223See, e.g., Martin J. McMahon Jr., ‘‘Economic Substance, Purposive Activity, and Corporate Tax Shelters,’’ Tax Notes, Feb. Doc 2002-4664, 2002 TNT 38-32. (‘‘uncertainty created by the application of these judicial doctrines should not be viewed as a problem worse than the problem their application is intended to remedy. . . . Without the uncertainty these doctrines create, mastery of the intricacies of nooks and crannies of the Code and regulations would become even more valuable for both tax practitioners and their clients.’’) 224See Isenbergh, supra note 113, at 864-865. (‘‘Many of the basic terms of the Code are . . . imported into it with their contours already set. . . . The underlying idea — that it does not matter what things are called — is common to all law. No label can make a diamond of a rhinestone. This principle is more than sufficient to defeat transactions that are simply shams.’’) 225See Scalia, A Matter of Interpretation 23-24 (Princeton Univ. Press 1997). (‘‘A text should not be construed strictly, and it should not be construed leniently; it should be construed reasonably, to contain all that it fairly means. . . . I am not a strict constructionist, and no one ought to be.’’). The distinction between a word’s ordinary meaning and its literal meaning is in Smith v. United States, U.S. 1993) (Scalia, J., dissenting). (‘‘In the search for statutory meaning, we give nontechnical words and phrases their ordinary meaning . . . [To ‘‘use’’] an instrumentality ordinarily means to use it for its intended purpose. When someone asks, ‘Do you use a cane?’ he is not inquiring whether you have your grandfather’s silver-handled walking stick on display in the hall; he wants to know whether you walk with a cane. Similarly, to speak of ‘using a firearm’ is to speak of using it for its distinctive a weapon. be sure, ‘one can use a firearm a number of ways,’ ante, at 2055, including as an article of exchange, just as one can ‘use’ a cane as a hall decoration — but that is not the ordinary meaning of ‘using’ the one or the other.’’) 226See, e.g., Leocal v. S. (2004). (‘‘we natural meaning’’) (internal quotation marks omitted)); Sale v. COMMENTARY /next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT nonetheless authorize[d] the claimed deductions,"215 find-court ing of the economic substance docto undertake that analysis and reached the opposite trine inappropriate. Stating claimed tax benefits "section 108 due judiciary's play „216 Congress's one wondering the court has simply applied a "smell test."222 Such tests over whether stat-do little to further the integrity of the legal system and ute's than a is frivo-lous.217 "One may nonetheless argue that, as a policy matter, of verbal communica-judicial prevent taxtion, depends the idea that words have some mean-payers from manipulating the code.223 But many tax ing,"218 and statutory observed, statutes contain substantive principles, and a taxpayer's an "objective constraint on [a judge's] conduct."219 labels should interpreta-In some cases, of course, applying a statute (rather tion of those even the absence judicial doctrine) not make a substantive judicially created doctrines.224 Substance should always In a judicial trump form when Congress enacts a substantive provimerely serve as an "anodyne for the pains of reason-sion. secure ing,"220 and if a court the sales, a taxpayer sells property for $100 and, under a analysis, it will find against the taxpayer.221 For example, prearranged plan, buys it back 10 seconds the it not the transactions denied not because property. property. Statutory language must be given its fair, fail made test, but ordinary meaning 225 not its strict, literal meaning 226 and circular transfers of funds and rights create genuine, distinct leases and should not be respected as such. See Rev. Rul. 2002-69, 2002-2 C.B. 760, 222 Doc 2002-23195, 2002 TNT 199-1. See ACM, 157 F.3d at 265 (McKee, J., dissenting) ("I can't suspect majority's conclusion something a 'smell test.' If the scheme question smells avoid taxes we tax aver to 'put one over."'). 215Id. ("following the parties' assumptions F2TSee, e.g., Martin J. McMahon "Economic Substance, transactions were not into and Corporate Tax Shelters," Tax Notes, Feb. profit no evidence nontax 25, 2002, p. 1017, Doc 2002-4664, 2002 TNT 38-32. ("The uncerbusiness purpose, we to tainty created the application of these judicial doctrines authorizes the claimed deductions.") problem problem 216See Lerman, 939 F.2d at 52. ("[these is intended to remedy... Without the uncertainty tax purposes, section 108 mastery of come into play") become 217See also Robert Thornton "Business clients.") the Citadel," 53 Tax Law. 1, ("224See Isenbergh, 113, 864-865. ("to the than an terms of are ... imported into it their app2r1o8priate Code.") set... underlying idea -that it does Simpson v. United States, 183 F.3d 812 (8th Cir. 1999) called -is common law. Arnold continued, "the inge-a diamond rhinestone. This principle nuity of lawyers can usually scrape defeat shams.") on which to hang a hat. But judges 225See Scalia, A Matter of Interpretation 23-24 (Princeton substantial uncertainty ("text should not be construed a statute, the statute as unless be construed should be construed nonsense, to contain all that it fairly means... of that kind." Id. and no be."). The distinction 219Hon. "What I Ate for Breakfast word's meaning Decision Making," 26 Loy. L.A. L. Rev. 993, illustrated in Smith v. United States, 508 U.S. 223, 242 (1993) ("Language has meaning. This doesn't J., dissenting). ("In for statutory is every other word, nontechnical phrases ordinary meanalways does ing ... "use"] means statutes, its intended purpose. When someone 'use conduct.") cane?' he is not inquiring grandfather's 220Commissioner 60 2d the he J.). with a cane. Similarly, speak 221See, e.g., Dean Weiner and Christopher W Campbell, 'firearm' speak for its distinctive "Results? -Coltec Industries and Castle purpose, i.e., as a weapon. To be sure, 'one can use a firearm in Harbour," 34 Tax'n that two ways; ante, 2055, shelter cases could have been decided in favor of the govern-just as one can 'use' a cane as a hall decoration -ment resort to a free-floating doctrine); Glassman, supra 'using' the other.") tax shelter transactions 226See, e.g., Leocal v. Ashcroft, 543 U.S. 1, 9 (2004). ("When "would have been interpreting a statute, we must give words their ordinary or without the economic substance doctrine"). meaning") (internal quotation marks omitted)); Sale v. (Footnote continued on next page.) 988 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315an illusory transfer followed by an interdependent retransfer does not ordinarily constitute a sale. Similarly, if a statute provides tax benefits to a corporation that distributes property to its shareholders, and if a corporation uses its shareholders as a mere conduit to transfer property to one of its creditors, any claimed tax benefits should be denied.227 A stockholder who receives property from a corporation and, as a condition of that transfer, to immediately give that corporation’s creditor can hardly be considered the distributee, as that term is ordinarily understood.228 The creditor, the corporation cannot argue that it has distributed property to its shareholders. the language a statute does make taxpayer’s of economic substance principles 229 For example, tax benefits to the title owner of property, the economic incidents of ownership are irrelevant.230 Similarly, if a taxpayer has bona fide ownership in stock, and that stock 317(b) must apply, even if the taxpayer has no business purpose for holding or selling that stock—section 317(b) simply does not look to a taxpayer’s motive.231 And if a all property in exchange for materially different property, there can be no doubt that a disposition has occurred, even if the taxpayer purposes. Indeed, because the Supreme Court consistently taxpayer’s tax avoidance motive,232 the lower courts should not say that statutes may be ignored if ‘‘the taxpayer’s sole subjective motivation is tax avoidance even if the transaction has economic substance.’’233 Absent some statutory indication that a taxpayer’s motive is relevant, lower courts should focus on what was done, not why it was done. Only when Congress says taxpayer’s motive is relevant—does — should a court examine a taxpayer’s reasons for entering into a transaction.234 In all other cases, the lower courts should respect the legislature’s choice and apply the statute as written.235 Centers 199 (1993) (Blackmun, J., dissenting). (‘‘‘We have considered ourselves bound to assume that the legislative purpose is expressed by the ordinary meaning of the words used.’ Ordinary, but not literal.’’) (Emphasis supplied.) 227See Minn. 302 U.S. (transfer of cash by corporation to its stockholders did not constitute ‘‘distribution’’ to those stockholders under section 112(d)(1) and (2) of the Revenue Act of 1928 when stockholders had, prior to the transfer, agreed to use those funds to pay off the corporation’s creditors). 228See Black’s Law Dictionary (8th ed. 2004) (defining distributee as a ‘‘beneficiary entitled to payment’’). A person who takes a payment from another subject to the legal obligation to transfer that payment to another is not ‘‘entitled’’ to that 229See also Isenbergh, supra note 113, at 879. (‘‘When we are dealing with statutory terms of art, the form-substance dichotomy is a false one. ‘Substance’ can only be derived from forms created by the statute itself. Here substance is form and little else; there is no natural law of reverse triangular mergers.’’); Robert Willens, ‘‘The Myths of Form and Substance in C,’’ Tax Notes, 2, 1999, p. 739, Doc 1999-25752, 147-76. 230Cf. also Isenbergh, supra note 113, at 872-873. (‘‘All that the liquidation of a corporation ever entails is a transfer of title in its assets. When an artificial entity disappears, there results a change in the form of ownership of property. Indeed, it is hard to think of what else happens in a liquidation other than a change in the formal indicia of ownership.’’) 231Section 317(b) provides that ‘‘stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.’’ That statute plainly looks to whether stock is exchanged for property, and not to why the exchange took place. The Claims Court blundered badly in holding otherwise in Heinz, conducting the taxpayer’s claimed tax benefits. See supra note 93. 232See Gregory, 293 U.S. at 469 (stating that ‘‘the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended’’ and ‘‘putting aside . . . the question of motive in respect of taxation altogether’’); Knetsch, 364 U.S. at 365 (setting aside the lower court’s factual finding that Knetsch was motivated by tax savings); Consumer Life, 430 U.S. at 739. (‘‘Even a ‘major motive’ to reduce taxes will not vitiate an otherwise substantial transaction.’’); Frank Lyon, 435 U.S. at 580. (‘‘The fact that favorable tax consequences were taken into account by Lyon on entering into the transaction is no reason for disallowing those consequences. We cannot ignore the reality that the tax laws affect the shape of nearly every business transaction.’’) See also Dewees, 870 F.2d at 29 (Breyer, J.) (‘‘The Court [in Gregory] examined only the transaction on its face, not the motives of the taxpayer.’’); Bittker and Lokken, Federal Income Taxation of Income, Estates, & Gifts, para. 4.3.2. (‘‘A tax-avoidance purpose serves only the preliminary purpose of advising the IRS and courts where to dig; it does not help in deciding whether what is actually found belongs on the taxable or the nontaxable side of the statutory line.’’) 233Coltec, 3d Some courts do hold tax-avoidance motive alone does not justify the disregard of statutes. See, e.g., Carrington v. Commissioner, 476 F.2d 704, 706 (5th Cir. 1973). (‘‘The mere fact that the transactions here questioned were concededly designed to limit Carrington’s tax liability establishes nothing with regard to the question of the these transactions.’’) quotations, and alterations omitted.) 234See, e.g., section 162(a) (limiting deductions to those made in the carrying on of a trade or business); section 170(f)(9) (denying charitable deductions that are made to avoid application of section 162(e)); section 269 (denying tax benefits obtained through the acquisition of a corporation, in which ‘‘the principal purpose for which such acquisition was made is evasion or avoidance of Federal income tax’’); section 269A (dealing with personal service corporations that are formed or availed of for the purpose of avoidance or evasion of tax); section 269B(b) (granting the secretary authority to ‘‘prescribe such regulations as may be necessary to prevent avoidance or evasion of Federal income tax through the use of stapled entities’’); section 306(b) (excepting transactions from the operation of 306(a) in which the taxpayer is not motivated to avoid tax); section 355(a)(1)(D) (taxpayers cannot retain stock in a section 355 transaction unless that retention was ‘‘not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax’’); section 357(b) (excepting tax avoidance plans from the operation COMMENTARY /next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT transfer by an interdependent re-taxpayer relinquishes all rights in property in exchange transfer constitute a sale. materially different property, there a corpo-a disposition has occurred, the taxpayer ration to its shareholders, performed the transaction solely for tax avoidance pura conduit poses. the Court disregards a taxpayer's tax avoidance motive 232 be denied.227 A stockholder receives not say statutes a "the taxpayer's sole motivation avoidtransfer, agrees to immediately give that property to the ance even if the transaction has economic substance."233 corporation's be dis-statutory taxpayer's motributee, term is ordinarily understood.228 tive distributee is the creditor, and the corporation cannot it was done. Only when Congress says to its shareholders. that a taxpayer's motive is relevant -which it frequently But if the language of a statute does not make a -should a court examine a taxpayer's reasons taxpayer's motives or a change in its economic position entering into a transaction.234 In all other cases, the relevant, the application of economic substance prin-lcoowuertrs legislature's ciples is unwarranted.229 For example, if Congress grants the statute as written.235 owner of property, the economic ownership are irrelevant.230 Similarly, if fide is acquired by the issuer in exchange for property, section 232See Gregory, 293 U.S. at 469 (stating that "the question the taxpayer has no business stock -section 317(thing statute intended" and "putting simply does not look to a taxpayer's motive.231 And if a ... the of respect taxation altogether"); Knetsch, U.at 365 (setting aside the lower court's that Knetsch was motivated by tax savings); Life, 430 U.S. at 739. ("Even a 'major motive' not vitiate an otherwise substantial transaction."); Haitian Centers Council, Inc., 509 U.S. 155, 199 (1993) (Blackmun, Lyon, ("that favorable tax ("'as-were taken into account by Lyon on entering sume by those consequences. used.' literal.") Empha-sis su7pplied.) every business transaction.") See also Dewees, 22 See Minn. Tea Co. v. Helvering, 302 U.S. 609, 613 (1938) Breuer, J.) ("Gregory] of stockholders not not the motives of taxpayer."); "distribution" to those stockholders under section Lokken, Federal Income Taxation Income, & 4.3.2. ("tax-only prelimihad, to the transfer, funds nary to corporation's not deciding whether is actually found 228See Black's Law Dictionary (8th ed. 2004) (defining distribu-tee a "beneficiary entitled payment"). takes line. '2 another to obligation 23. Coltec, 454 F.3d at 1355. Some courts do hold that a that to another is not "entitled" that motive alone does not justify payment. See, g., Commissioner, 229See also Isenbergh, supra note 113, at 879. ("When Cir. ("that the transactions here statutory terms of art, the form-substance di-designed to limit Carrington's chotomy 'Substance' can only be derived establishes regard is proper taxation of these transactions.") (internal citations, quolittle else; of reverse merg-tations, ers."); "Form and Substance 234See, e.g., section 162(a) (limiting deductions Subchapter C," Tax Notes, Aug. 2, 1999, p. 739, Doc 1999-25752, the carrying on of a trade or business); section 1999 TNT 147-76. applica-230Cf. Isenbergh, supra note 113, at 872-873. ("All that tion 269 (denying of a corporation ever corporation, in which "principal When an disappears, such acquisition was made evasion in the form tax"); (dealing with of what else happens liquidation other than a corporations that are formed or chan e ownership.") avoidance or evasion of tax); section 269B(23 Section 317(b) provides that "be treated as "prescribe by corporation acquires to prevent for the use stapled entities"); section 306(acquired retired, treasury stock." from the a) in to whether stock is exchanged to avoid tax); section 355(why the exchange place. a holding otherwise in Heinz, conduct-"in pursuance as ing a long inquiry into the taxpayer's motives in denying it its purposes the avoidance Federal tax"); tax benefits. See 93. b) (excepting tax avoidance plans from the operation (Footnote continued on next page.) TAX NOTES, September 10, 2007 989 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315possible consequence of its legislation, so judicial intervention from benefits in a manner unforeseen by the statutory drafters.236 As one commentator put it, adhering to a statute’s is ‘‘misguided’’ ‘‘statute must be applied to fact patterns that Congress did not consider when it enacted the statute.237 But, as a unanimous the ‘fact that Congress may not have foreseen all of the consequences of a statutory enactment is not a sufficient reason for refusing effect its plain meaning.’’’238 ‘‘statute be ‘applied anticipated by Congress does not demonstrate ambiguity. It demonstrates breadth.’’’A draftsman’s lack of foresight disregard statutory language,240 and courts should apply the provisions of the code to even novel transactions. One may nonetheless argue that the approach outlined be when statutory language perfectly clear. For example, it may be difficult to determine own it, or to determine how much profit one must seek to be engaged in the carrying on of a trade or business, or to different. A court might thus have to apply the economic substance doctrine whenever it is faced with an ambiguous statute. But that argument is based on the dubious can apply the economic substance doctrine but apply how much economic substance statute requires, it probably cannot determine how much economic substance requires, either. The ‘‘dizzingly complex’’241 doctrine has numerous formulations and is embodied in the same medium (the written word) that Congress’s laws are in. statutory language inherently and inescapably ambiguous, the same must be true of the economic substance doctrine. The problems posed by ambiguous statutory language cannot be avoided by doctrine. The argument that the code is too difficult to interpret is particularly unavailing in light of the fact that many of the Statutes If can interpret words like ‘‘ownership,’’ ‘‘business,’’ ‘‘stock,’’ ‘‘partnership,’’ ‘‘indebtedness,’’ ‘‘disposition’’ in nontax statutes, those same words when they are used in tax statutes.242 Although some argue that the tax laws have distinct of 357(a)); section 467(b) (requiring ‘‘constant rental accrual in case of certain tax avoidance transactions’’); section 532 (imposing tax on corporations ‘‘formed or availed of for the purpose of avoiding the income tax with respect to its shareholders’’); section 631(c) (excluding corporations used to avoid income tax on shareholders from the subsection’s general rule); section 845(a) (allowing the secretary to recharacterize a reinsurance agreement involving tax avoidance or evasion); section 877 (addressing expatriations undertaken to avoid tax); section 1272(a)(2)(E)(ii) (excepting a loan from the application of section 1272(a)(2)(E)(i) ‘‘if the loan has as 1 of its principal purposes the avoidance of any Federal tax’’). 235See United v. Great N. (‘‘It is our judicial function to apply statutes on the basis of what Congress has written, not what Congress might have written.’’) 236Perhaps a general antiabuse rule is desirable to discourage from aggressive code. Indeed, one can fairly criticize Congress for failing to codify an economic substance test. But even if a general antiabuse rule would improve social welfare, there is no reason that the courts (as opposed to the legislature) must create that test. Surely, Congress is empowered to enact a statute that says ‘‘Economic substance is a prerequisite to any provision of the code allowing deductions.’’ See also Weisbach, ‘‘Ten Truths,’’ supra note 9, at 218. (‘‘If [judicial doctrines] are desirable for independent reasons, Congress can incorporate them directly into the statute.’’). A vague statute will likely face political opposition, but the fact that the people’s representatives will not enact a statute does not mean that the courts should invent a doctrine that has the equivalent effect of that statute. Rather, Congress should take it upon itself to improve the proposals currently under consideration so they are palatable to the public. While the current proposals do suffer from significant flaws and should not be enacted, see infra note 275, Congress should follow one commentator’s suggestion and immediately codify a narrow rule that eliminates the worst of the loopholes in the code, leaving the knottier issues to be resolved later. See David P. Hariton, ‘‘Stop Calling It Economic Substance,’’ Tax 1544, 2003-111-51. 237Zelenak, supra note 13, at 659. 238Lockhart United States, (O’Connor, J., for a unanimous Court) (quoting Union Bank v. Wolas, 502 U.S. 151, 158 (1991) (Stevens, J., for a unanimous Court)). See also Oncale v. Sundowner Offshore Servs., Inc., 523 U.S. 75, 79 (1998) (unanimous). (‘‘[I]t is ultimately the provisions of our laws rather than the principal concerns of our legislators by which we are governed.’’), and K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 323 (Scalia, J., concurring) (1988) (‘‘A 19th-century statute criminalizing the theft of goods is not ambiguous in its application to the theft of microwave ovens simply because the legislators enacting it ‘were unlikely to have contemplated’ appliances.’’). 239Pennsylvania Dept. of Corrections v. Yeskey, 524 U.S. at 212 (unanimous). West Virginia University Hospitals, U.S. 83 at 100 (‘‘Thus, the argument runs, the 94th Congress simply forgot; it is our duty to ask how they would have decided had they actually considered the question. See Friedrich v. Chicago, 888 F.2d 511, 514 (7th Cir. 1989) (awarding expert fees under section 1988 because a court should ‘‘complete . . . the statute by reading it to bring about the end that the legislators would have specified had they thought about it more clearly’’). This argument profoundly mistakes our role.’’). 241Bankman, supra note 9, at 29. 242This is not to say that a word must have a single, fixed meaning regardless of statutory context. Rather, it is a ‘‘fundamental principle of statutory construction (and, indeed, of language itself) that the meaning of a word cannot be determined in isolation, but must be drawn from the context in which is used.’’ Deal v. United States, S. Nonetheless, it should not be too difficult for a court to determine that the word ‘‘indebtedness’’ in section 163(a) does not mean ‘‘only indebtedness incurred with a business purpose in a transaction that is not motivated by tax and which results in a significant change in the obligor’s net economic position as measured by the excess of the taxpayer’s expected return over the risk-free rate of return.’’ The meaning of ‘‘indebtedness’’ might not be perfectly determinate, but the definition just COMMENTARY /next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT One may argue that Congress cannot anticipate every pated Congress of its legislation, so judicial inter-breadth."'239 A draftsman's lack forevention is needed to prevent taxpayers from claiming tax sight cannot justify the disregard of statutory lanbenefits by draft-guage 240 and courts should apply the provisions ers.236 As one commentator put it, adhering to a statute's plain language is "fundamentally misguided" when "a nonetheless argue that outstatute lined here will be useful only when statutory language is consider when it enacted the statute.237 For example, it may be difficult deterunanimous court recently warned, the 'fact that Congress mine what rights one must have in property to actually have foreseen of the consequences much profit one must seek to give effect to its plain meaning."'238 Indeed, "that a determine whether two properties are materially differstatute can be 'applied in situations not expressly antici-ent. court might thus have to apply the economic doctrine whenever it with assumption that a court can apply the economic subof section 467(b) (requiring "stance doctrine but cannot apply statutory language. If a of certain transactions"); impos-court cannot determine how much economic substance a ing "it income with respect to its shareholders"); c) (excluding corporations to economic substance the economic substance doctrine shareholders the subsection's section "complex"241 has the secretary to recharacterize a reinsurance embodied the same involving avoidance or evasion); section 877 word) that Congress's laws are expatriations undertaken to tax); section embodied in. If statutory language is inherently and ii) loan from ambiguous, the same must be true i) "1 of its principal doctrine. The avo2i3d5ance tax"). See United States v. Great N. Ry. Co., 343 U.S. 562, 575 (1952). applying a judicial doctrine. ("is function to apply statutes on the basis Con ress written, might written.") code is too difficult 2 6Perhaps general antiabuse rule light of the fact taxpayers from taking overly aggressive interpretations of the its terms and phrases are found elsewhere in the Statutes Indeed, one can fairly for failing at Large. If courts can interpret words like "ownership," an economic test. But a general "business," "stock," "partnership," "indebtedness," and improve social welfare, there is no reason "disposition" in nontax statutes, surely they can interpret create those same words when they are used in tax statutes.242 is empowered says have distinct "is a prerequisite to any provision deductions." See also "Truths," 218. ("doctrines] Congress can incorporate them statute."). will likely face political 239Pennsylvania Yeskey, 524 people's will does not mean that 240Cf. Virginia ("has equivalent effect of that statute. Rather, simply forgot; it should take it improve the proposals to ask how they would have decided actually consideration so the the question. See Friedrich v. Chicago, 888 F.511, the current proposals significant expert fees under section 1988 and should not be enacted, see infra note 275, Congress a court should "complete ... one commentator's about the end that the legislators have specified that eliminates the loopholes more clearly"). This argument proin code, the knottier issues to be resolved later. See foundly mistakes role."). P. "Stop Calling It Economic Substance," Tax 241Bankman, 29. Notes, June 9, 2003, p. 1544, Doc 2003-13889, 2003 TNT 111-51. 242This must have a single, 237238Zelenak, 13, 659. of statutory it is a "funda-Lockhart v. United States, 126 Sup. Ct. 699, 702 (2005) mental of statutory construction O'Connor, for (quoting Union Bank v. itself) cannot be deter-S. J., for mined in See Ofshore Servs., S. it is used." Deal v. United States, 508 U.S. 129, 132 (1993). 79 (1998) (unanimous). ("[I]t is ultimately it should not be too difficult for concerns "indebtedness" in section 163(a) does we are governed."), and K Mart Corp. v. Cartier, Inc., 486 "indebtedness a business ("19th-not motivated obligor's net economic as of microwave ovens simply because of taxpayer's return enacting it 'to have contemplated' return." The meaning of "indebtedness" those appliances."). not be perfectly determinate, definition just (Footnote continued on next page.) 990 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315features that demand unique methods of interpretation,243 ‘‘the Code is just another statute, which suffers from the same ailments that have afflicted legislative enactments since Parliament first tampered with the common law.’’244 Indeed, it is a ‘‘firmly established principle of statutory interpretation that ‘the words of statutes — including revenue acts — should be interpreted where possible in their ordinary, everyday senses,’’’245 and there is little justification for abandoning that principle, even if it means that a court has to find in a taxpayer. B. Civil and Criminal Penalties Even if the Court decides that ‘‘statutory details’’246 need not be examined in tax cases, it should state that a taxpayer cannot be penalized for disregarding the code’s ‘‘rules or regulations’’247 when the reviewing court itself disregards those rules or regulations, or when the reviewing court finds that the taxpayer has complied with the applicable rules or regulations.248 The section penalty, by its taxpayer’s failure comply of code.The IRS’s argument that ‘‘resulting application of the economic substance doctrine’’250 is sheer applesauce. The Supreme Court should state that it is inappropriate for the IRS and the lower courts to apply those code sections that impose penalties while disregarding those sections that grant taxpayers benefits. If the substantive provisions of subtitleAare ignored, the penal provisions of subtitle F should be ignored as well, particularly because the application of the penal provisions depends heavily on the construction of the substantive provisions.251 Similarly, a taxpayer should be imprisoned only if he has failed to comply with the laws of Congress. A created is a whether he has complied with those laws has no place in a criminal trial. Commentators may advocate the use of ‘‘multiple, sometimes conflicting doctrines’’252 to deny taxpayers statutory benefits in civil matters, but ‘‘dizzingly complex’’253 judicial tests with ‘‘few bright lines’’254 should not be applied in criminal proceedings. If the Court nonetheless holds that it is appropriate to go ‘‘outside the statutory framework’’255 in criminal trials, and that ‘‘mere compliance’’ with Congress’s statutes is insufficient to escape conviction, it should, if nothing else, make the formulation of the economic substance doctrine crystal clear. It is easy to get the impression that there are as many versions of the doctrine as there are code sections, and it is perverse to imprison a taxpayer for failing to comply with a judicial even lower courts cannot apply consistently.256 C. Legislative Acquiescence Because lower courts have used the economic substance doctrine to override statutes for decades, one might argue that Congress, via legislative silence, has signaled its approval of a free-floating doctrine.257 The Court, however, should reject that argument. If Congress is deemed to have acquiesced to a judicial method of interpretation, surely it should be deemed to have acquiesced to the Supreme Court’s statute-focused method the ‘‘inferior’’ courts’ that method.258 It would be strange to conclude that Congress has acquiesced to a doctrine that contradicts the Court’s jurisprudence. offered is obviously too narrow. ‘‘Indebtedness’’ appears hundreds of times in the United States Code, and courts may draw from the numerous opinions and treatises construing that term to aid in their construction of section 163(a). 243See, e.g., Zelenak, supra note 13, at 630. 244Boris I. Bittker and Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts, para. 4.2.1 (3d ed. 2001). See also Livingston, supra note 15, at 686. (‘‘Scholars in other fields tend to be unimpressed by the assertion of tax uniqueness, noting that the assertedly special features of taxation—detail, revision, and underlying structural principles — are shared in varying degrees by other laws. This is particularly true of broad, programmatic statutes like the Uniform Commercial Code, programs.’’) 245Hanover Bank v. Commissioner, 369 U.S. 672, 687 (1962) (quoting Crane v. Commissioner, 331 U.S. 1, 6 (1947)). 246In re Holdings, 301 F.at 102. 247Section 6662(b)(1). (‘‘This section shall apply to the portion of any underpayment which is attributable to . . . negligence or disregard of rules or regulations.’’) 248See Compaq, supra Part II.C. 249Section 6662(c) provides: ‘‘Negligence. — For purposes of this section, the term ‘negligence’ includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term ‘disregard’ includes any careless, reckless, or intentional disregard.’’ Because the doctrine is uncodified, a taxpayer’s failure to comply with the doctrine cannot constitute the failure to comply with the provisions of the code. 250IRS 200217021, 82-74. See FSA 200150011, Doc 242-(‘‘There is precedent for recovering the negligence penalty in an economic substance case so we would assert that penalty.’’) 251See supra note 249. See also section 7201. (‘‘Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title shall . . . be guilty of a felony.’’) (Emphasis added.) A court cannot possibly determine whether a taxpayer has evaded the tax imposed by the Internal Revenue Title if it disregards the provisions that determine the amount imposed. 252Shaviro and Weisbach, supra note 9, at 513. See also McMahon, supra note 223. 253Bankman, supra note 9, at 29. 254Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313, 1316, TNT Cir. 2001), cert. denied, 255Dewees, 870 F.2d at 34 (emphasis removed). 256See infra note 267. 257See Bankman, supra note 9, at 11. (A somewhat strong assertion ‘‘is that the legislature assumes that long-standing common law doctrines such as economic substance will be used to interpret the statutes it enacts. Under this claim, the doctrines have been implicitly adopted as part of the statute — at least where the statute does not indicate otherwise.’’) 258See U.S. Constitution, Article III, sec. 1. (‘‘The judicial power of the United States, shall be vested in one Supreme COMMENTARY /next page.) (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT that methods interpreta-subtitle A are tion,243 "Code just another statute, suffers of should be ignored as well, the same afficted legislative because the application of provienactments since Parliament first tampered with the sions substancommon law."244 it a "firmly established tive provisions.251 'imprisoned -including revenue -should be inter-preted their ordinary, everyday comply the laws of Congress. senses,"'245 and there is little justification for abandoning judicially created doctrine that is a prerequisite to determining whether he has those laws has means to find Commentators may advocate favor of a taxpayer. use of "multiple, sometimes conficting doctrines"252 to and Criminal Penalties statutory in matters, "dizzingly complex"253 judicial tests with "few bright Even if the Court decides that "statutory details"246 lines"254 should not be applied in criminal proceedings. cases, it the code's holds "regulations"247 when the reviewing go "outside the statutory framework"255 criminal those rules or or re-"mere compliance" with Congress's statviewing that the with utes escape conviction, it applicable rules or regulations.248 section of the economic 6662(b)(1) negligence penalty, by its plain terms, applies doctrine crystal clear. It is the only to a taxpayer's failure to comply with the provisions docof the code.249 The IRS's argument that the "negligence trine as there are and perverse penalty can be applied to deficiencies resulting from the for of the economic substance doctrine"250 test that even the lower courts cannot apply consissheer The Supreme Court should that tently.256 the lower Acquiescence that lower economic doctrine override statutes for decades, one argue that Congress, legislative silence, has signaled its approval of a free-foating doctrine.257 The narrow. "Indebtedness" appears hun-reject Congress dreds States and courts may to a surely it should be deemed acquito their construction of section 163(a). esced Supreme Court's statute-focused 243See, e.g., Zelenak, 630. rather than to the "inferior" courts' misunderstanding of 244Boris Bittker and Lawrence Lokken, Federal Taxation that method.258 would be strange to conclude and ed. See also acquiesced to a doctrine that contradicts supra ("in other Court's assertion tax uniqueness, special features of taxation -principles -are shared by other laws. This of broad, like Uniform Commercial Code, 251 See supra note 249. See also section 7201. ("Any person who environmental legislation, and many regulatory programs.") attempts in any manner to evade or defeat 245Hanover v. Commissioner, 369 1962) by this title shall... be guilty felony") (Emphasis quo24t6ing 1947)). In re CM Holdings, 301 F.3d at 102. the tax imposed by Title if 247Section 6662(b)(1). ("This section shall apply to the portion imposed. ... negligence 25 Shaviro Weisbach, supra note See also disre and regulations.") supra note 223. 24 See Compaq, supra Part 253Bankman, 29. 249Section 254Winn-Dixie Stores, Inc. v. Commissioner, 254 F."-For purposes of this section, Doc 2001-18038, 2001 TNT 127-6 (11th Cir. 2001), cert. denied, 535 'negligence' to make a reasonable U.S. 986 (2002). and 255Dezuees, 870 F.2d at 34 (emphasis removed). 'disregard' includes any careless, reckless, 256See infra disregard." 257See Bankman, supra note somewhat the doctrine is uncodified, taxpayer's "that the legislature assumes long-standing the doctrines such as will with25 t0he provisions of the code. the IRS FSA 200217021, Doc 2002-10141, 2002 TNT 82-74. See implicitly as part of the statute -at least also IRS FSA 200150011, Doc 2001-30791, 2001 TNT 242-25 otherwise.") ("258See U.S. Constitution, Article sec. ("case so we would assert that penalty") the United States, shall be vested in one Supreme (Footnote continued on next page.) TAX NOTES, September 10, 2007 991 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315One may nonetheless argue that the various legislative proposals to codify the doctrine indicate that Congress is aware of the doctrine, and that it has acquiesced to its creation.259 But one can just as easily argue that the legislature’s numerous refusals to codify the doctrine reflect its disapproval of it.260 It is for good reason that ‘‘failed legislative proposals are ‘a particularly dangerous ground on which to rest an interpretation of a prior statute.’’261 ‘‘inaction measure of congressional intent,’’262 and ‘‘it is at best treacherous to find in Congressional silence alone the adoption of a controlling rule of law.’’263 Indeed, ‘‘Congress no legislation,’’264 and its lawmaking powers ‘‘may only ‘be exercised in accord with a single, finely wrought and exhaustively considered procedure’’’265 described in Article I of the Constitution. But even if the Court concludes that Congress can legislate via acquiescence, and even if the Court concludes that it is the lower courts’ free-floating doctrine to which the legislature may acquiesce, the Court should not find that the doctrine has been incorporated into the ‘‘legislative acquiescence best for use interpreting ambiguous statutory provisions’’266 and should not be used to muddle the meaning of the tax laws. There are fundamental differences in the lower courts’ formulations of the doctrine and it is hard to believe that Congress has sanctioned a conjunctive doctrine in some circuits, a disjunctive doctrine in others, a unitary doctrine in still some others, and a rejection of the doctrine in another.267 even to believe that Congress has acquiesced to the various intracircuit conflicts regarding the doctrine — different panels of judges view the economic substance doctrine differently.268 Even if Congress may legislate by doing nothing, it is impossible to determine Court, and in such inferior courts as the Congress may from time to time ordain and establish.’’) 259See, e.g., CARE Act, S. 476, 108th Cong., 701 2003). 260See Helvering S. 120 (1940) (‘‘explain the cause of non-action by Congress when Congress itself sheds no light is to venture into speculative unrealities’’); Johnson v. Transportation Agency, 480 U.S. 616, 672 (1987) (Scalia, J., dissenting) (it is ‘‘impossible to assert with any degree of assurance that congressional failure to act represents (1) approval of the status quo, as opposed to (2) inability to agree upon how to alter the status quo, (3) unawareness of the status quo, (4) indifference to the status quo, or even (5) political cowardice’’). 261United S. 274 (2002) (quoting Pension v. Corp., U.S. 262Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 222 n.7 also Red Lion Co. v. 367, 381-382 n. 11 (1969). (‘‘Unsuccessful attempts at legislation are not the best of guides to legislative intent.’’) 263Girouard States, S. (1946). 264Rapanos v. States, (plurality opinion). See also United States v. Estate of Romani, 523 98 (1998) (Scalia, J., dissenting). (‘‘The act of refusing to enact a law (if that can be called an act) has utterly no legal effect, and thus has utterly no place in a serious discussion of the law. . . . Congress can no more express its will by not legislating than an individual Member can express his will by not voting.’’) 265Clinton City of New York, 524 U.S. 417, 439-440 (1998) J.) v. Chadha, 462 S. 266Jones v. Liberty Co., 332 U.524, 533-534 (1947). Even when the Court applies the legislative acquiescence canon, it applies it to only a ‘‘consistent judicial interpretation of a statute.’’ Monessen Southwestern Ry. Co. v. Morgan, 486 U.S. 330, also United v. Powell, 379 U.(1964) (refusing to apply canon when there was no ‘‘settled judicial construction’’ at time of reenactment). The lower courts’ application of the economic substance doctrine is neither ‘‘consistent’’ nor ‘‘settled.’’ See infra note 267. Further, the doctrine does not represent the ‘‘judicial interpretation’’ of a statute, but rather the judicial disregard of one. See supra Part II. 267Some courts apply a conjunctive substance and hold that if a taxpayer fails either one of the test’s prongs, its transaction will be disregarded. See, e.g., Coltec, supra Part II.A, and Winn-Dixie Stores, Inc. v. Commissioner, supra note 254. (‘‘A transaction is not entitled to tax respect if it lacks economic effects or substance other than the generation of tax benefits, or if the transaction serves no business purpose.’’) (Emphasis added.) Other courts apply a disjunctive test and hold that if a taxpayer has either a nontax motive or an expectation of profit, his transaction will be respected. See Rice’s Toyota World, Inc. v. 752 F.2d 89, 91 (4th Cir.1985). Still others apply two factors together. See ACM, 157 F.3d at 247. (The ‘‘distinct aspects of the [economic substance doctrine] do not constitute discrete prongs of a ‘rigid two-step analysis,’ but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax to be respected for purposes.’’) omitted.) Courts even define the individual prongs of the economic substance doctrine differently. For example, some courts focus on a taxpayer’s subjective motivations in determining whether his conduct reveals a business purpose, while on objective factors. Compare 2d 1549 (9th (‘‘The business purpose factor often involves an examination of the subjective factors which motivated a taxpayer to make the transaction at issue.’’), with Coltec, 454 F. 3d at 1359 (‘‘Economic substance is measured from an objective, reasonable viewpoint, not by the subjective views of the taxpayer’s corporate officers.’’). The preceding cases do not present an exhaustive list; there are even more formulations of the doctrine than those described here. Acomprehensive discussion of the lower courts’ approaches may be found in the literature cited in note 9. This report is primarily concerned with those courts that use the doctrine in its strongest form (that is, those that use it to disregard statutory language) and not those, like the D.C. Circuit in Horn, that use it as an aid in construing statutory language. 268Compare, e.g., Howell v. United 775 F.2d 887, 887 (7th Cir. 1985) (Easterbrook, J.). (‘‘This exalts form over substance, no doubt. In tax, however, form and substance often coincide. . . . A court must apply an empty distinction with the same fidelity as applies any other.’’), with Yosha v. Commissioner, 861 F.494, 498 (7th Cir. 1988) (Posner, J.) (expressing approval of the economic substance doctrine). See also Magee and Goldman, supra note 4, at 488 (noting that, with regard to an appellate court’s standard of review, ‘‘taxpayers are treated differently based solely on which circuit (or, in some circuits, which panel) hears the appeal’’). COMMENTARY /continued (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT argue that the various the tax laws. There fundaproposals indicate that Congress mental in the courts' it has acquiesced is hard to believe that Congress has 259 as easily the a doctrine some legislature's refusals to doctrine a unitary of it.260 It reason the doctrine in another.267 "legislative proposals 'It is even harder to believe that Congress has acquiesced rest interpretation statute."261 "Congressional inaction is generally a poor measure of congressional intent,"262 and "it is at best -different panels of judges view the economic substance 268 Even if legtreacherous to in Congressional silence islate nothing, it is impossible to determine adoption of a controlling rule of law."263 Indeed, "Congress takes no governmental action except by legislation,"264 and its lawmaking powers "may only 'be exercised in accord a single, finely wrought and exhaustively considered procedure"'265 described in Ar-construction" at time of reenactment). courts' ticle the economic doctrine "consistent" "settled." See 267. the Court concludes that Congress can not the "judicial interpretation" a and even if con-judicial disregard of one. See supra cludes that it lower courts' foating courts apply a conjunctive economic substance test the legislature may acquiesce, if a taxpayer fails either one of the test's that the doctrine has transaction will be disregarded. See, e.g., Coltec, supra code. The canon of "legislative acquiescence is at best ILA, and Winn-Dixie Stores, Inc. v. Commissioner, supra 254. only an auxiliary tool for use in interpreting ambiguous ("transaction to tax respect it lacks economic statutory provisions"266 be used to other the transaction serves no business purpose.") hold nontax motive of will be respected. See Rice's Toyota v. such inferior courts as the Congress Commissioner, 752 F.2d 89, 91 (4th Cir.1985). Still others apply the tim2e5 9to and establish.") factors together. See ACM, 3d at (The "See, e.g., CARE Act, S. 476, 108th Cong., section 701 (2003). of doctrine] do 260See Helvering v. Hallock, 309 U.S. 106, 119-120 (1940) ("To prongs of 'two-step analysis,' repreexplain cause non-action by Congress when Congress sent factors both of which no light speculative unrealities"); apart from v. Transportation consequences, to be respected for tax purposes.") (Citations "impossible to assert any degree define the the that failure act represents ap-doctrine example, some proval the status to agree taxpayer's subjective motivations in determinupon to alter the status quo, (3) unawareness ing whether his conduct reveals a business to even others focus on objective factors. Compare Bail Bonds by Marvin cowardice"). Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987) 261 United States v. Craft, 535 U.S. 274 (2002) (quoting Pension ("purpose factor ofen Benefit Guaranty Corporation v. LTV Corp., 496 U.S. 633, 650 which (1990)). issue."), with Coltec, ("262Arkansas is measured from viewpoint, (1988). See also Red Lion Broadcasting Co. v. FCC, 395 U.S. 367, by the subjective of the taxpayer's corporate offi-("cers."). do not2 t6h3e intent.") doctrine than those Girouard v. United States, 328 U.S. 61, 69 (1946). A comprehensive discussion of the lower courts' 264Rapanos v. United States, 126 Sup. Ct. 2208, 2231 (2006) may be found in note opinion). See also United States v. Estate of Romani, concerned those courts use U.S. 517, 535-536, Doc 98-13919, 98 TNT 84-9 (1998) (Scalia, J., its strongest that it ("that can and not the D.C. utterly and utterly Horn, as an aid in construing statutory of the law... lan wage. its will not legislating 68Compare, e.g., Howell v. United States, 775 F.2d 887, 887 (7th express his will by not voting.") (("265Clinton v. City of New York, 524 U.S. 417, 439-440 (1998) often coincide... (Stevens, J.) (quoting INS v. Chadha, 462 U.S. 919, 951 (1983) the same as (punctuation omitted). it applies any other."), with Yosha v. Commissioner, 861 F.2d 494, 266Jones v. Liberty Glass Co., 332 U.S. 524, 533-534 (1947). Even Cir. J.) approval Court applies the legislative acquiescence See Magee and it only a "consistent judicial interpretation a note 4, at 488 (noting that, regard an appellate statute." Monessen S. court's review, "taxpayers 338 (1988). See also United States v. Powell, 379 U.S. 48, 55, n. 13 on which canon "settled appeal"). (Footnote continued in next column.) 992 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315which court’s or which panel’s formulation of the doctrine it has silently enacted into law. It is the Court’s ‘‘duty to make sense rather than nonsense out of the corpus juris,’’269 and holding that Congress has quietly free-doctrines among the circuits does little to discharge that duty.270 Holding that Congress, through its silence, has simply granted the lower courts the power to rewrite statutes any opinion appropriate formulation of the doctrine) is similarly untenable. ‘‘The verdict of quiescent years cannot be invoked to is otherwise impermissible.’’271 The Constitution provides that the tax laws must originate in the House of Representatives — not in the federal district and circuit courts.272 Congress cannot delegate lawmaking powers to the courts, either affirmatively or through its acquiescence.273 If Congress wants an economic substance test to apply to all tax statutes, it constitutionally obliged to create that test itself.274 Indeed, there are strong arguments in favor of codification, and Congress should give them careful consideration.275 D. Underlying Purpose and Economic Shams state to underlying purpose are inappropriate interpreting the code. In an economic substance case, the question is whether Congress granted the taxpayer the claimed benefit. If a court states that, regardless of statutory Congress’s underlying taxpayer that benefit, it has simply turned a blind eye to legislature’s purpose by ignoring the words that it uses to articulate its purpose.That approach is simply self-defeating. Even 269West Virginia University Hospitals, Inc. v. Casey, 499 U.S. 83, 101 (1991). Of course, this principle can apply only to the extent that text of a statute permits. See United States v. Olympic Radio Television, Inc., 349 U.S. 232, 236 (1955). (‘‘We can only take the Code as we find it and give it as great an internal symmetry and consistency as its words permit.’’) 270In perhaps the most famous tax case applying the legislative acquiescence canon, Bob Jones v. United States, the Court applied the canon only after finding ‘‘overwhelming evidence of Congressional awareness and acquiescence’’ (461 U.S. at 602 n.27 supplied).) The Court in Bob Jones cautioned against drawing inferences from legislative silence, but found that the numerous hearings Congress held on the ‘‘precise issue’’ before the Court warranted the application of the canon. See id. at 600. (‘‘and quite appropriately, courts are slow to attribute significance to the failure of Congress to act on particular legislation. . . . Here, however, we do not have an ordinary claim of legislative acquiescence. Only one month after the IRS announced its position in 1970, Congress held its first hearings on this precise issue.’’) But even in Bob Jones, the Congress interpretation of an enacted statute, not whether Congress had acquiesced to the judiciary’s disregard of an enacted statute. The Court has yet to address whether the legislature can acquiesce to the disregard of its own laws. 271Zuber 396 U.S. 168, 185-186, 21 (1969). 272See U.S. Constitution, Article I, sec. 7. (‘‘All bills for raising revenue shall originate in the House of Representatives.’’) 273See Wayman v. Southard, 23 U.S. 1, 43 (1825) (C.J. Marshall). (‘‘It will not be contended that Congress can delegate to the Courts, or to any other tribunals, powers which are strictly and exclusively legislative.’’) 274See supra note 272. 275See Marvin Chirelstein and Lawrence Zelenak, ‘‘Tax Shelters and the Search for a Silver Bullet,’’ 105 Colum. L. Rev. 1939 (2005), for a thoughtful proposal to codify a noneconomic loss disallowance provision in the code. See also Samuel C. Thompson Jr., ‘‘Despite Widespread Opposition, Congress Should Codify the Economic Substance Doctrine,’’ Tax Notes, Feb. 13, 2006-2513, 2006 TNT 30-38; Monte Jackel, ‘‘Better or for Worse: Codification of Economic Substance,’’ Doc 9475, 2004 TNT 96-33 (May David Weisbach, ‘‘The Failure of Disclosure as an Approach to Shelters,’’ 54 SMU L. Rev. 73 (2001). In recent years, Congress has in fact considered various proposals to codify the economic substance doctrine. But those proposals have been poorly drafted and, even if enacted, would do little to address this report’s concerns because they simply state that the doctrine may apply whenever a court considers it ‘‘relevant.’’ See, e.g., S. 96, 110th Cong., section 201 (2007) (providing for a conjunctive test ‘‘in any case in which a court determines that the economic substance doctrine is relevant for purposes of this title’’). As discussed in parts II and III, supra, the doctrine is never relevant to the Supreme Court and some lower courts, but it is relevant to, for example, the Third and Federal circuits. Enacting a statute that supposes that the doctrine might possibly be ‘‘relevant’’ accomplishes nothing, and the Court’s intervention will still be required. If Congress does want an economic substance test to prerequisite the operation of any code section allowing a tax benefit, it should say so, rather than enact a ‘‘circular’’ statute. See Brant Goldwyn, ‘‘Congress Expected to Adopt Codification of Economic Substance Doctrine, Hill Staffer Says,’’ CCH Federal Tax Day (May 18, 2007). (One panelist ‘‘objected to introductory language that applies the statute to any case ‘in which a court determines that the economic substance doctrine is relevant.’ He said this is circular and does not clarify the doctrine.’’) Alternatively, Congress may consider granting the secretary broad authority to disallow benefits obtained under tax-motivated transactions, as long as the delegating statute yields some intelligible principle to which his regulations must conform. See Whitman v. American Trucking 2001). 276See supra note 10. See also The Paulina, 11 U.S. 52, 61 (1812) (C.J. Marshall). (‘‘In construing these laws, it has been truly stated to be the duty of the court to effect the intention of the legislature; but this intention is to be searched for in the words which the legislature has employed to convey it.’’); Aldridge v. Williams, 3 How. 9, 24 (1845) (‘‘In expounding this law, the judgment of the court cannot, in any degree, be influenced by the construction placed upon it by individual members of Congress in the debate which took place on its passage, nor by the motives or reasons assigned by them for supporting or opposing amendments that were offered. The law as it passed is the will of the majority of both houses, and the only mode in which that will is spoken is in the act itself.’’); United States v. S. (‘‘and general rule of statutory construction is that the intent of the lawmaker is to be found in the language that he has used.’’); 178 U.S. 510, 520 (1900). (‘‘Of course, our duty is to give effect to the will of Congress touching this matter. But we must ascertain that will from the words Congress has chosen to employ, interpreting such words according to their ordinary meaning.’’); United States v. Bitty, 208 U.S. 393, 401 (1908). (‘‘All will admit that full effect must be given to the intention of Congress as gathered from the words of the statute.’’) COMMENTARY /continued (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT court's panel's the doc-Underlying Purpose and Economic Shams trine has silently enacted into is the Court's The Court should state that references to an underly-"to make sense than nonsense out ing purpose are inappropriate when interpreting the juris,"269 that Congress an economic substance sanctioned numerous unique free-floating doctrines among the circuits does little to discharge that duty claimed 270 a court states that, regardless statutory that Congress, simply language, Congress's underlying purpose is to deny the to rewrite statutes eye (but has not expressed any opinion regarding the appro-the issue. Courts cannot determine the legislature's purpriate of the untenable. pose by uses "of quiescent purpose 276 That approach is simply baptize a statutory gloss that is otherwise impermissible."271 laws of Representatives -the federal district and circuit courts.272 Congress cannot "Shelters," lawmaking affirma-73 (2001). In recent years, Congress has in fact considered tively or through its acquiescence.273 If Congress wants codify the economic substance doctrine. test to apply have been poorly drafted is constitutionally obliged to create that test itself.274 would little to address this report's concerns strong arguments in codifica-they simply that the doctrine may apply tion, and Congress them careful consider-considers it "relevant." See, e.g., S. ation.275 (2007) (providing "in any case which a court determines that the economic substance title"). As discussed and III, supra, the doctrine never relevant the Court lower but 269West Hospitals, Inc. v. Casey, S. (1991). Of course, this principle can apply that the doctrine might "relevant" accomthat the text of a statute permits. See United States v. Olympic plishes nothing, and the Court's will be Inc., 349 U.S. 232, 236 (1955). ("We can only Congress an economic substance we find an internal svmmetrv apply as a prerequisite to the operation of any code section as its words permit.") tax benefit, should say so, rather than enact a 2701n perhaps the most famous tax applying legisla-"circular" statute. See "Congress Expected tive acquiescence Bob v. United the Codification of Economic Substance Doctrine, Hill after finding "overwhelming Says," Federal 18, acquiescence" 602 "language (emphasis supplied)) The Court in Bob Jones cautioned 'which a court determines that the economic but doctrine relevant.' does the numerous hearings held the "precise the doctrine.") Alternatively, Congress issue" of the canon. secretary disallow benefits id. ("Ordinarily, and quite appropriately, courts are transactions, delslow significance to the of Congress egating yields some intelligible principle legislation... we have must conform. See Whitman v. American Trucking claim of legislative acquiescence. Only one month afer Associations, 531 U.S. 457, 472 (2001). its 1970, held 276See supra note also The Pauline, precise issue.") But even in Bob Jones, ("construing question was whether Congress acquiesced to an agency inter-the duty pretation an enacted statute, not whether Congress had is to be for to the judiciary's of an enacted the legislature has convey it."); Aldridge v. to address the legislature can acquiesce 9, 24 (1845) ("expounding law, the t2h7e1 laws. the court cannot, any degree, Zuber v. Allen, 396 U.S. 168, 185-186, n.21 (1969). placed upon it individual members 272See U.S. Constitution, Article I, sec. 7. ("All bills in passage, rev2e7n3ue the House of Representatives.") reasons by them for See Wayman v. Southard, 23 U.S. 1, 43 (1825) (C.J. Marshall). were offered. The as passed ("will not be contended that Congress can delegate of the majority of both houses, that will is spoken is in the act itself."); United States v. legislative.") Goldenberg, 168 U.S. 95, 102-103 (1897). ("The primary and 274See supra rule is 275See Marvin "Tax Shel-be in the language that he has used."); ters Search a Silver Bullet," 105 Colum. L. Rev. 1939 Dewey v. United States, 178 U.S. 510, 520 (1900). ("Of course, our for a thoughtful codify a noneconomic loss is of Congress in the code. See also Thomp-ascertain from the words Congress has son "Despite Widespread Opposition, Congress Should to interpreting the Economic Substance Doctrine," Tax Notes, Feb. 13, meaning."); United States S. 2006, p. 781, Doc 2006-2513, 2006 TNT 30-38; Monte Jackel, "For ("will admit that full effect must be given to the Worse: of Economic Substance," Doc Congress as from the the 2004-9475, 2004 TNT 96-33 (May 3, 2004); David A. Weisbach, statute.") (Footnote continued in next column.) TAX NOTES, September 10, 2007 993 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315a taxpayer engages devoid of economic substance),‘‘barring constitutional infirmity, Congress undoubtedly has the power to grant beneficial tax treatment to economically meaningless behavior.’’Lower courts should follow the Supreme Court’s approach and examine whether Congress has exercised that power,not just blindly assume that a transaction that does not pass a judicial test is inconsistent with the code’s hidden, underlying purpose.280 Given that the lower courts deliberately ignore the text of the code, it is not even clear how they determine its accepts ‘‘underlying purpose’’ as a canon the lower courts have stretched it well beyond its fair 281 The Federal Circuit conjured an underlying to contradict statutory language.282 The Third Circuit did the same to disregard statutory language altogether.283 If ‘‘underlying purpose’’ has a role to play in statutory interpretation, it is limited to clarifying the language, contradicting or negating it.284 Indeed, ‘‘vague notions of a statute’s ‘purpose’ . . . inadequate overcome the words of its text regarding the specific issue under consideration.’’285 This is not to say that courts should adopt hyperliteral interpretations of the code or blithely sanction sham transactions.286 A fair reading of sections 1 and 11 indicates that their purpose (as reflected by their text) is to raise revenue.If a taxpayer offers a hyperliteral interpretation of a substantive provision that would render sections 1 and 11 a dead letter, a court should reject that interpretation.288 But there is a significant difference between an interpretation that (if accepted) would render 277See supra note 64 for a discussion of the distinction between a factual sham and an economic sham. Although economic shams should not be disregarded unless a court statutory it entirely to disregard factual shams. If something does not actually occur, there is nothing for a court to analyze, and a court is not statutory language if it ignores that nonoccurrence. 278Horn, 968 F.1234. 279See supra Part III. 280See Isenbergh, supra note 113, at 879. (‘‘Hard grappling with the facts of a case and the inner workings of a statute, although both difficult and intellectually admirable, is frequently passed off as a trivial or excessively ‘formal’ exercise. . . . [Acourt will instead make] an inquiry about the ‘larger’ nature of the statute itself. The latter exercise is in fact quite easy, the assertion a purpose that encapsulates one’s own tastes, either generally or regarding the transaction under scrutiny.’’) 281In Heinz, discussed supra note 93, the Court of Federal Claims concluded that the economic substance doctrine is not ‘‘a judicial gloss on the Code,’’ but is ‘‘merely a judicial tool for effectuating the underlying Congressional purpose that, despite literal compliance with the statute, tax benefits not be afforded based on transactions lacking in economic substance.’’ See Heinz, 454 F.3d at 1354). It is hard see how a doctrine that allows a court to disregard statutes is not a ‘‘judicial gloss.’’ If the economic substance doctrine does is not a judicial gloss, then nothing is. Indeed, the doctrine falls squarely within the Supreme Court’s definition of federal law. See Atherton v. F.I.C., 519 U.S. 213, 218 (1997). (Federal common law is ‘‘a rule of decision that amounts, not an interpretation a federal promulgated administrative rule, but, rather, to the judicial ‘creation’ of a special federal rule of decision.’’) The doctrine does not require a court to interpret a federal statute, or even cite one, to deny a taxpayer a benefit. See supra Part II. Indeed, many courts openly state that they are applying a judicially created doctrine rather than statutory language. See, e.g., In re 301 F.108. 282See supra Part II.A. 283See supra Part II.B. 284See Director, Office of Workers’ Compensation Programs, Dept. of Labor v. Newport News Shipbuilding and Dry Dock Co., 514 U.S. 122, 135-136 (1995). (‘‘[T[he Director retreats to that last redoubt of losing causes, the proposition that the statute at hand should be liberally construed to achieve its purposes. . . . That principle may be invoked, in case of ambiguity, to find present rather than absent elements that are essential to operation of a legislative scheme; but it does not add features that will achieve the purposes’ more effectively. statute only to achieve certain ends, but also to achieve them by particular means — and there is often a considerable legislative battle over what those means ought to be.’’) 285Mertens Hewitt Assocs., 508 U.S. 248, 262 (1993). See also Board of Governors of Federal Reserve System v. Dimension Financial S. (‘‘of ‘plain purpose’ of legislation at the expense of the terms of the statute itself . . . prevents the effectuation of congressional intent.’’); Durham, supra note 89, at 35. (‘‘The statute is . . . the clearest and best evidence of Congress’ intent, and any analysis of economic substance that does not take into account the words of the statute will inevitably lead to a usurpation of Congress’ proper role.’’) 286As a general rule, courts should not adopt a taxpayer’s hyperliteral interpretation of a code provision. Rather, the language of the statute and its context (particularly, surrounding statutes) should be rigorously examined. ‘‘Statutory construction . . . is a holistic endeavor.’’ United Sav. Ass’n of Texas v. Ltd., (Scalia, J.). See also Davis v. Michigan Dept. of Treasury, 489 U.S. 803, 809 (1989). (‘‘Although the State’s hypertechnical reading of the [statute] is not inconsistent with the language of that provision examined in isolation, statutory language cannot be construed in a vacuum. It is a fundamental canon of statutory construction that the words of a statute must be read in their context and with a view to their place in the overall statutory scheme.’’) If a tax statute yields several plausible meanings, a lower court can and should apply the one that comports best with the remainder of the code. However, if the text of a tax statute (fairly interpreted) is unambiguous, nothing is left to judicial construction, and a lower court should apply the statute according to its terms. See United States v. Fisher, 2 Cranch 358, 386 (1805) (C.J. Marshall). This is so even if it means that a taxpayer will enjoy a windfall or suffer a harsh result. See Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 93 (1934); Commissioner v. Wodehouse, 337 U.S. 369, 380 (1949); Hanover Commissioner, U.S. and v. Commissioner, 531 U.S. 206 at 220. See also N. Jerold Cohen, ‘‘Too Good to Be True and Too Bad to Be True,’’ Tax Notes, Dec. 12, 2005, 238-287Section imposes a tax on individuals. Section 11 288See Cooper Industries, Inc. v. Aviall Services, Inc., 543 U.S. 157, 158 (2004) (it is a ‘‘settled rule that the Court must, if a statute to some effect’’). COMMENTARY /continued (C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT if a taxpayer engages in a sham transaction (that is, one statute's 'basic purpose' are ... inadequate to overcome of economic substance) 277 "barring constitutional its text regarding the specific issue Congress consideration."285 treatment to economically meaningless that courts should adopt hyperliteral behavior."278 Lower courts should the Supreme of blithely sanction sham Court's approach and examine whether Congress has 286 A fair reading of 1 and indiexercised that 279 not just blindly cates that their reflected by their inconsis-287 If a taxpayer offers a hyperliteral intertent the code's hidden, underlying purpose.280 pretation render a dead letter, a court even 288 there is a significant difference underlying purpose. But even if the Court accepts "un-interpretation would derlying purpose" as a legitimate canon of construction, it use.281 The Federal Circuit conjured an underlying purpose statutory language.282 The Third Cir-135-136 (1995). ("[T[he Director retreats to that cuit the same to disregard statutory language alto-the proposition gether.283 If "underlying purpose" has a role to play its purposes... it is clarifying the of ambiguity meaning of ambiguous statutory language, not contra-that to operation dicting or negating it.284 "but it features achieve the statutory purposes' more effectively. Every statute proposes, not to achieve achieve -and there is ofen a considerable those be.") 277See a discussion the distinction 285Mertens v. Hewitt Assocs., 508 U.S. 248, 262 (1993). See also an economic sham. Reserve System v. Dimension Financial shams should disregarded court Corp., 474 U.S. 361, 374 (1986). ("Invocation of the 'plain examines statutory language, it is of course entirely appropriate purpose' legislation at the expense congressional intent."); court to analyze, not supra at 35. ("The statute is ... overriding statutory language if it ignores that nonoccurrence. Congress' 278Horn, 968 F.2d at 1234. that does not take into the the 279See supra Part inevitably lead to a usurpation of Congress' 280See Isenbergh, 879. ("grappling role.") the facts of a case of a statute, 286As adopt a taxpayer's and intellectually admirable, fre-hvperliteral a code provision. Rather, the quently off or excessively 'formal' exer-surroundcise.. A court instead 'larger' ing statutes) examined. "Statutory connature The latter exercise fact easy, struction ... is a holistic endeavor." United Sav. Assn of texas v. requiring only the assertion of a statutory purpose that encap-Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 371 (1988) sulates one's own regarding the also Davis v. of Treasury, S. scrutiny.") 809 (1989). ("Although State's hvpertechnical reading 2811n Heinz, discussed supra note 93, the Court Federal is inconsistent with language that doctrine "examined isolation, statutory language cannot Code," but "Congressional the statute, tax benefits and with place in economic substance." See scheme.") statute several plausible meanings, 76 Fed. Cl. at 592 (quoting Coltec, 454 F.3d at 1354). It is hard to can apply the one that comports best how to disregard statutes the remainder the code. if "gloss." If the economic substance does interpreted) nothing is gloss, construction, the within Supreme Court's federal to its terms. See United States 358, common law. See Atherton v. F.D.I.C., 519 U.S. 213, 218 (1997). J. Marshall). This is so even if means common law "decision amounts, will enjoy a windfall or suffer a harsh result. See simply to an interpretation of a federal statute or a properly v. Stockholms Enskilda Bank, S. rule, but, to Wodehouse, S. Hanover 'creation' decision.") The Bank v. Commissioner, 369 U.S. 672, 687 (1962); and Gitlitz v. a federal statute, even 531 U.206 at 220. See also N. Jerold Cohen, "a taxpayer a benefit. See Part Be True and Too Bad to Be True," Tax Notes, Dec. 12, that 2005 p. 1437, Doc 2005-23498, 2005 TNT 238-26. than statutory language. See, e.re 297Section 1 imposes a tax on individuals. Section 11 imposes CM Holdings, 301 F.3d at 108. a tax on corporations. 282See supra Part II.288See Cooper Industries, Inc. v. Aviall S. 283See supra Part a "settled 284See Director, Ofce of Workers' Compensation possible, construe a statute to give every word some operative Dock Co., 514 S. effect"). (Footnote continued in next column.) 994 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315the code a nullity and one that simply suggests that Congress has (wisely or unwisely) subsidized a transaction.If a fair interpretation of the statutory language indicates that Congress did grant benefits to a sham transaction, courts should follow the Supreme Court’s guidance and respect the legislature’s intent.290 One might nonetheless argue that any interpretation transaction is inherently perhaps even absurd.291 But the issues are far more than that. a sham transaction is broad enough to reach a transaction that even a saint would undertake. Suppose, for example, that wishes states that investments placed in special accounts will not a taxpayer transfers from tax-sheltered account. That transfer does nothing to affect the taxpayer’s beneficial interest except to reduce tax and will fail both prongs of the economic substance test. The taxpayer is savings in transferring her investments, so she will fail the subjective prong. Further, because ‘‘the transaction to benefit,’’292 it is the transfer between the accounts (and overall investment) that must be analyzed. Because that transfer tax saving umbrella, it does nothing to alter the flow of benefits to her and will of the test. Under the Coltec approach, at least, the taxpayer’s transfer of funds would be disregarded and she would be taxed as if her funds remained in the Of course, it is highly unlikely that a court would disregard the taxpayer’s ‘‘mere compliance’’ with the statute, or that the IRS would bother to challenge the taxpayer’s challenge reviewing court would almost certainly analyze the transaction by reference to the statute. Nonetheless, in the context of transactions involving business entities, the lower courts are inclined to skip an examination of Congress’s words and go straight to the economic substance doctrine. It is hard to see the justification for that approach. Congress is empowered to subsidize both retirement ‘‘backflips,’’ too.293 Although it is doubtful that taxmotivated transactions—whether they relate to business retirement accounts — improve social welfare,294 whether a statute reflects ‘‘wise or unwise policy . . . is not a question that [a] [c]ourt is authorized to consider,’’295 and a court’s inquiry should be limited to determining whether a taxpayer’s transaction falls within of the applicable statute.296 then-Judge Stevens observed in dissent, even if the legislature enacts a dubious test for claiming a tax benefit, a court must ‘‘apply the test which Congress has specified,’’ ‘‘nonstatutory’’ one.297 taxpaying public, of course, can (and should) question the wisdom of 289For a discussion of arguments that would, if accepted, render the code a nullity, see ‘‘The Truth About Frivolous Tax Arguments’’ (Nov. 30, 2006), available at http://www.irs.gov/pub/irs-utl/friv_tax.pdf. 290Of course, when the will of Congress is inimical to the Constitution, courts must respect the intent of the framers and that of Congress. See Marbury v. Madison, 5 U.S. 137, 178 291Although commentators are often quick to argue that respecting the form of a tax-motivated transaction would be ‘‘absurd,’’ the absurdity doctrine should not be invoked merely because the code dictates an objectionable result. Rewriting a statute because it is ‘‘absurd’’ is an extraordinary step and should be taken in only the most extraordinary circumstances. Sturges v. Crowinshield, 17 U.S. (4 Wheat.) (C.J. Marshall). (‘‘If, in any case, the plain meaning of a provision, not contradicted by any other provision in the same instrument, is to be disregarded, because we believe the framers of that instrument could not intend what they say, it must be one in which the absurdity and injustice of applying the provision to the case, would be so monstrous, that all mankind would, without hesitation, unite in rejecting the application.’’) 292Id. 293See Schler, supra note 9, at 385-386. (‘‘If Congress enacts a tax credit for backflips, Congress has determined that backflips are socially desirable. If a taxpayer learns to do backflips and earns the credit, it is doing nothing wrong. On the contrary, in the view of Congress, the taxpayer adds to the overall social welfare. . . . When Congress enacts a tax incentive, it presumably determines (correctly or not) that there is an overall benefit to society if taxpayers engage in the desired behavior.’’) 294For a list of (often dubious) social programs that are through Joint Committee Taxation, ‘‘Estimates of Federal Tax Expenditures for Fiscal Years 2006-2010,’’ Joint Committee Print, 109th Cong., 2d sess., JCS-2-06. Washington: Government Printing Office. Doc 2006-TNT also Thomas L. Hungerford, ‘‘Tax Expenditures: Good, Bad, or Ugly?’’ Tax Notes, Oct. 23, 20976, 2006 TNT 205-39 (observing ‘‘tax expenditures income distribution, and they often subsidize an activity for which the taxpayer receives a benefit. Further, research has questioned the effectiveness of some tax expenditures in achieving the stated social objectives’’). 295Southern Motor Carriers Rate Conference, Inc. v. United States, Ct. See also Drilling Co., 505 S. (1992). (‘‘is the duty of the courts to enforce the judgment of the Legislature, however much we might question its wisdom or fairness.’’) That a particular interpretation will open the door for taxpayers to reduce their tax liabilities cannot itself justify the disregard of statutory language. Cf. Caminetti v. United States, 470, 490-491 (1917). (‘‘The fact, if it is written opens the door to blackmailing operations upon a large scale, is no reason why the courts should refuse to enforce it according to its terms, if within the constitutional authority of Congress. Such considerations are more appropriately addressed to the legislative branch of the government, which alone had authority to enact and may, if it sees fit, amend the law.’’) 296See supra note 10. 297Economy Finance Corp. v. United States, 501 F.2d 466, 485-486 (7th Cir. 1974) (Stevens, J., dissenting). (‘‘I am persuaded that the government’s conclusion [regarding eligibility under section 801] . . . rests on a nonstatutory standard. Congress may have acted unwisely. . . . Nevertheless, we must, of course, apply the test which Congress has specified.’’) COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT and one that simply suggests skip an examination has (wisely or a transac-Congress's words the economic subtion.289 If a fair interpretation language stance did sham courts should the Supreme Court's is hard to see the justification for that approach. guidance and respect the legislature's intent.290 is retirement nonetheless argue that accounts and business transactions, and perhaps even that sanctions a sham transaction is inherently unfair, or "backflips," too.293 is doubtful that taxperhaps even absurd.291 the issues more motivated transactions -whether they relate to business nuanced than that. The judicial definition of a sham transactions or retirement accounts -improve social reach welfare,294 whether a statute refects "wise or unwise saint would ... is not a question Congress wishes to encourage retirement savings and consider,"295 and a court's inquiry should be limited to that investments in accounts will taxpayer's falls within be subject to any tax. Suppose further that a taxpayer the terms of the applicable statute 296 Indeed, as thentransfers investments from a preexisting account to a observed in dissent, even if a dubious test for taxpayer's "apply the test which Congress has specified," fail both prongs of the economic substance test. rather than a "nonstatutory" one.297 The taxpaying pubtaxpayer (by assumption) is motivated solely by tax lic, course, and the wisdom in so she will "be analyzed is the one that gave rise to the alleged tax benefit,"292 it is the transfer between the accounts (and not her overall investment) that must be analyzed. Be-293See Schler, supra note 9, at 385-386. ("If cause that transfer merely puts her investments under a backflips, Congress umbrella, it does nothing to alter the fow If economic benefits to her and will fail the objective prong the credit, it the test. Under the Coltec approach, least, the of Congress, social taxpayer's of be disregarded welfare... a tax incentive, presumshe her funds remained the ably preexisting account. s2o94ciety taxpayers behavior.") For are it administered through the tax code, see joint Committee on taxpayer's "compliance" with "Fiscal or bother to challenge 2010," Joint Committee 109th Cong., 2d sess., taxpayer's transfer. If the IRS did challenge the transfer, a 2-06. Washington: Government Printing Office. Doc 2006-almost certainly analyze the 7856, 2006 TNT 80-14 (2006). See also Thomas L. Hungerford, "Ugly?" Tax Notes, Oct. 23, 2006, p. 325, Doc 2006-20976, 2006 TNT 205-39 (observing that transactions business many "tax expenditures go to taxpayers in the upper part of the the taxpayer receives 'a benefit. Further, research has tax expenditures achiev-289For if accepted, ing stated objectives"). "Tax 295Southern Carriers Rate Conference, States, Arguments" available at http://www.gov/105 S. Ct. 1721, 1738 (1985) (Stevens, J., dissenting). See also Estate pub /irs-utl/of Cowart v. Nicklos Drilling Co., 505 U.S. 469, 483-484 (1992). ("It 2900f course, of Congress the duty of the courts to enforce the judgment the however much we might not that of Congress. See Marbury v. Madison, 5 U.S. fairness.") a particular interpretation open (1803). to their tax liabilities 291Although commentators are often argue that statutory language. Cf Caminetti v. United States, the form tax-be 242 U.S. 470, 490-491 (1917). ("The fact, if it be so, that the act as "absurd," opens the to blackmailing operations the code dictates an result. is no reason why it is "absurd" an extraordinary step and terms, if within the most extraordinary circumstances. Such considerations are more ad-See Sturges v. Crowinshield, 17 U.S. (4 Wheat.) 122, 202-203 (1819) dressed to the legislative government, ("in any case, the plain meaning a to enact sees law.") in the same 296See supra is to be because 297Economy Corp. United States, what they say, must be (7th Cir. (Stevens, J., dissenting). ("I am persuaded which the absurdity and injustice applying the government's [eligibility to the case, would that all ... hesitation, unite in rejecting application.") unwisely... we course, 2921d. at 1356. the test Congress specified.") TAX NOTES, September 10, 2007 995 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315Congress’s policy decisions, but judicial legislation is not a constitutionally permissible solution to an imperfect tax V. Conclusion The approach outlined here is hardly a cure-all for the interpretive problems posed by the code. Agreeing to apply step solution. Courts must still examine that language to transaction must have economic substance, and, if so, how much is required. It is not to those determinations, but applying economic principles manner consistent with statutory language will improve the integrity of the tax laws. Nothing here suggests that Congress should encourage sham transactions or that courts should always tip the scales in favor of taxpayers. Optimal tax policy may require that taxpayers tests before claiming deductions and may even require tax rates much higher than those currently seen. This report is concerned with the courts’ proper role, however, and country’s proper tax system. goal here to take a fresh look at Supreme Court cases that have been misused and misunderstood by the lower courts. While courts should not take it on themselves to close loopholes in the code,298 Congress can and should aggressively amend statutes that reflect poor policy. Particularly bad statutes may even warrant retroactive repeal. Similarly, if public policy requires that taxpayers comply with an economic substance test before enjoying any statutory benefits, Congress should enact a statute providing that test. Until the doctrine is codified, however, the lower courts should let the debate remain where it belongs — in Congress — and should stop imposing a judicial test that has no basis in any Supreme Court decision. 298See Iselin v. United States, 270 U.S. 245, 251 (1926) (Brandeis, J.). (‘‘To supply omissions transcends the judicial function.’’) COMMENTARY /(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. COMMENTARY/SPECIAL REPORT Congress's policy but judicial with courts' role, however, not the country's proper tax system. The only goal here is system. take a fresh look at Supreme Court cases have courts. not take it on themselves to close outlined the code 298 Congress can and aginterpretive code. gressively that refect policy. Parapply statutory language is only the first step towards a ticularly bad statutes even retroactive resolution. examine that language peal. public policy requires that taxpayers determine whether a transaction must have economic an economic substance and, if so, how much is It benefits, Congress always easy to make those determinations, but applying test. the doctrine howeconomic substance principles in a manner consistent ever, the lower statutory -in Congress -and should stop imposing test has no basis in any Supreme Court here suggests encour-age transactions or that in favor of Optimal very well require that taxpayers meet strict statutory tests Iselin v. United States, 270 U.S. 245, 251(1926) (Brandeis, seen. ("the judicial function.") p 8 9m90r n 996 TAX NOTES, September 10, 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=687cfe50-6796-40c0-a905-e37d7f078315

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JD Supra Privacy Policy

Updated: May 25, 2018:

JD Supra is a legal publishing service that connects experts and their content with broader audiences of professionals, journalists and associations.

This Privacy Policy describes how JD Supra, LLC ("JD Supra" or "we," "us," or "our") collects, uses and shares personal data collected from visitors to our website (located at www.jdsupra.com) (our "Website") who view only publicly-available content as well as subscribers to our services (such as our email digests or author tools)(our "Services"). By using our Website and registering for one of our Services, you are agreeing to the terms of this Privacy Policy.

Please note that if you subscribe to one of our Services, you can make choices about how we collect, use and share your information through our Privacy Center under the "My Account" dashboard (available if you are logged into your JD Supra account).

Collection of Information

Registration Information. When you register with JD Supra for our Website and Services, either as an author or as a subscriber, you will be asked to provide identifying information to create your JD Supra account ("Registration Data"), such as your:

Email

First Name

Last Name

Company Name

Company Industry

Title

Country

Other Information: We also collect other information you may voluntarily provide. This may include content you provide for publication. We may also receive your communications with others through our Website and Services (such as contacting an author through our Website) or communications directly with us (such as through email, feedback or other forms or social media). If you are a subscribed user, we will also collect your user preferences, such as the types of articles you would like to read.

Information from third parties (such as, from your employer or LinkedIn): We may also receive information about you from third party sources. For example, your employer may provide your information to us, such as in connection with an article submitted by your employer for publication. If you choose to use LinkedIn to subscribe to our Website and Services, we also collect information related to your LinkedIn account and profile.

Your interactions with our Website and Services: As is true of most websites, we gather certain information automatically. This information includes IP addresses, browser type, Internet service provider (ISP), referring/exit pages, operating system, date/time stamp and clickstream data. We use this information to analyze trends, to administer the Website and our Services, to improve the content and performance of our Website and Services, and to track users' movements around the site. We may also link this automatically-collected data to personal information, for example, to inform authors about who has read their articles. Some of this data is collected through information sent by your web browser. We also use cookies and other tracking technologies to collect this information. To learn more about cookies and other tracking technologies that JD Supra may use on our Website and Services please see our "Cookies Guide" page.

How do we use this information?

We use the information and data we collect principally in order to provide our Website and Services. More specifically, we may use your personal information to:

Operate our Website and Services and publish content;

Distribute content to you in accordance with your preferences as well as to provide other notifications to you (for example, updates about our policies and terms);

Measure readership and usage of the Website and Services;

Communicate with you regarding your questions and requests;

Authenticate users and to provide for the safety and security of our Website and Services;

Conduct research and similar activities to improve our Website and Services; and

Comply with our legal and regulatory responsibilities and to enforce our rights.

How is your information shared?

Content and other public information (such as an author profile) is shared on our Website and Services, including via email digests and social media feeds, and is accessible to the general public.

If you choose to use our Website and Services to communicate directly with a company or individual, such communication may be shared accordingly.

Readership information is provided to publishing law firms and authors of content to give them insight into their readership and to help them to improve their content.

Our Website may offer you the opportunity to share information through our Website, such as through Facebook's "Like" or Twitter's "Tweet" button. We offer this functionality to help generate interest in our Website and content and to permit you to recommend content to your contacts. You should be aware that sharing through such functionality may result in information being collected by the applicable social media network and possibly being made publicly available (for example, through a search engine). Any such information collection would be subject to such third party social media network's privacy policy.

Your information may also be shared to parties who support our business, such as professional advisors as well as web-hosting providers, analytics providers and other information technology providers.

Any court, governmental authority, law enforcement agency or other third party where we believe disclosure is necessary to comply with a legal or regulatory obligation, or otherwise to protect our rights, the rights of any third party or individuals' personal safety, or to detect, prevent, or otherwise address fraud, security or safety issues.

To our affiliated entities and in connection with the sale, assignment or other transfer of our company or our business.

How We Protect Your Information

JD Supra takes reasonable and appropriate precautions to insure that user information is protected from loss, misuse and unauthorized access, disclosure, alteration and destruction. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. You should keep in mind that no Internet transmission is ever 100% secure or error-free. Where you use log-in credentials (usernames, passwords) on our Website, please remember that it is your responsibility to safeguard them. If you believe that your log-in credentials have been compromised, please contact us at privacy@jdsupra.com.

Children's Information

Our Website and Services are not directed at children under the age of 16 and we do not knowingly collect personal information from children under the age of 16 through our Website and/or Services. If you have reason to believe that a child under the age of 16 has provided personal information to us, please contact us, and we will endeavor to delete that information from our databases.

Links to Other Websites

Our Website and Services may contain links to other websites. The operators of such other websites may collect information about you, including through cookies or other technologies. If you are using our Website or Services and click a link to another site, you will leave our Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We are not responsible for the data collection and use practices of such other sites. This Policy applies solely to the information collected in connection with your use of our Website and Services and does not apply to any practices conducted offline or in connection with any other websites.

Information for EU and Swiss Residents

JD Supra's principal place of business is in the United States. By subscribing to our website, you expressly consent to your information being processed in the United States.

Our Legal Basis for Processing: Generally, we rely on our legitimate interests in order to process your personal information. For example, we rely on this legal ground if we use your personal information to manage your Registration Data and administer our relationship with you; to deliver our Website and Services; understand and improve our Website and Services; report reader analytics to our authors; to personalize your experience on our Website and Services; and where necessary to protect or defend our or another's rights or property, or to detect, prevent, or otherwise address fraud, security, safety or privacy issues. Please see Article 6(1)(f) of the E.U. General Data Protection Regulation ("GDPR") In addition, there may be other situations where other grounds for processing may exist, such as where processing is a result of legal requirements (GDPR Article 6(1)(c)) or for reasons of public interest (GDPR Article 6(1)(e)). Please see the "Your Rights" section of this Privacy Policy immediately below for more information about how you may request that we limit or refrain from processing your personal information.

Your Rights

Right of Access/Portability: You can ask to review details about the information we hold about you and how that information has been used and disclosed. Note that we may request to verify your identification before fulfilling your request. You can also request that your personal information is provided to you in a commonly used electronic format so that you can share it with other organizations.

Right to Correct Information: You may ask that we make corrections to any information we hold, if you believe such correction to be necessary.

Right to Restrict Our Processing or Erasure of Information: You also have the right in certain circumstances to ask us to restrict processing of your personal information or to erase your personal information. Where you have consented to our use of your personal information, you can withdraw your consent at any time.

You can make a request to exercise any of these rights by emailing us at privacy@jdsupra.com or by writing to us at:

You can also manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard.

We will make all practical efforts to respect your wishes. There may be times, however, where we are not able to fulfill your request, for example, if applicable law prohibits our compliance. Please note that JD Supra does not use "automatic decision making" or "profiling" as those terms are defined in the GDPR.

Timeframe for retaining your personal information: We will retain your personal information in a form that identifies you only for as long as it serves the purpose(s) for which it was initially collected as stated in this Privacy Policy, or subsequently authorized. We may continue processing your personal information for longer periods, but only for the time and to the extent such processing reasonably serves the purposes of archiving in the public interest, journalism, literature and art, scientific or historical research and statistical analysis, and subject to the protection of this Privacy Policy. For example, if you are an author, your personal information may continue to be published in connection with your article indefinitely. When we have no ongoing legitimate business need to process your personal information, we will either delete or anonymize it, or, if this is not possible (for example, because your personal information has been stored in backup archives), then we will securely store your personal information and isolate it from any further processing until deletion is possible.

Onward Transfer to Third Parties: As noted in the "How We Share Your Data" Section above, JD Supra may share your information with third parties. When JD Supra discloses your personal information to third parties, we have ensured that such third parties have either certified under the EU-U.S. or Swiss Privacy Shield Framework and will process all personal data received from EU member states/Switzerland in reliance on the applicable Privacy Shield Framework or that they have been subjected to strict contractual provisions in their contract with us to guarantee an adequate level of data protection for your data.

California Privacy Rights

Pursuant to Section 1798.83 of the California Civil Code, our customers who are California residents have the right to request certain information regarding our disclosure of personal information to third parties for their direct marketing purposes.

You can make a request for this information by emailing us at privacy@jdsupra.com or by writing to us at:

Some browsers have incorporated a Do Not Track (DNT) feature. These features, when turned on, send a signal that you prefer that the website you are visiting not collect and use data regarding your online searching and browsing activities. As there is not yet a common understanding on how to interpret the DNT signal, we currently do not respond to DNT signals on our site.

Access/Correct/Update/Delete Personal Information

For non-EU/Swiss residents, if you would like to know what personal information we have about you, you can send an e-mail to privacy@jdsupra.com. We will be in contact with you (by mail or otherwise) to verify your identity and provide you the information you request. We will respond within 30 days to your request for access to your personal information. In some cases, we may not be able to remove your personal information, in which case we will let you know if we are unable to do so and why. If you would like to correct or update your personal information, you can manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard. If you would like to delete your account or remove your information from our Website and Services, send an e-mail to privacy@jdsupra.com.

Changes in Our Privacy Policy

We reserve the right to change this Privacy Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our Privacy Policy will become effective upon posting of the revised policy on the Website. By continuing to use our Website and Services following such changes, you will be deemed to have agreed to such changes.

Contacting JD Supra

If you have any questions about this Privacy Policy, the practices of this site, your dealings with our Website or Services, or if you would like to change any of the information you have provided to us, please contact us at: privacy@jdsupra.com.

JD Supra Cookie Guide

As with many websites, JD Supra's website (located at www.jdsupra.com) (our "Website") and our services (such as our email article digests)(our "Services") use a standard technology called a "cookie" and other similar technologies (such as, pixels and web beacons), which are small data files that are transferred to your computer when you use our Website and Services. These technologies automatically identify your browser whenever you interact with our Website and Services.

How We Use Cookies and Other Tracking Technologies

We use cookies and other tracking technologies to:

Improve the user experience on our Website and Services;

Store the authorization token that users receive when they login to the private areas of our Website. This token is specific to a user's login session and requires a valid username and password to obtain. It is required to access the user's profile information, subscriptions, and analytics;

Track anonymous site usage; and

Permit connectivity with social media networks to permit content sharing.

There are different types of cookies and other technologies used our Website, notably:

"Session cookies" - These cookies only last as long as your online session, and disappear from your computer or device when you close your browser (like Internet Explorer, Google Chrome or Safari).

"Persistent cookies" - These cookies stay on your computer or device after your browser has been closed and last for a time specified in the cookie. We use persistent cookies when we need to know who you are for more than one browsing session. For example, we use them to remember your preferences for the next time you visit.

"Web Beacons/Pixels" - Some of our web pages and emails may also contain small electronic images known as web beacons, clear GIFs or single-pixel GIFs. These images are placed on a web page or email and typically work in conjunction with cookies to collect data. We use these images to identify our users and user behavior, such as counting the number of users who have visited a web page or acted upon one of our email digests.

JD Supra Cookies. We place our own cookies on your computer to track certain information about you while you are using our Website and Services. For example, we place a session cookie on your computer each time you visit our Website. We use these cookies to allow you to log-in to your subscriber account. In addition, through these cookies we are able to collect information about how you use the Website, including what browser you may be using, your IP address, and the URL address you came from upon visiting our Website and the URL you next visit (even if those URLs are not on our Website). We also utilize email web beacons to monitor whether our emails are being delivered and read. We also use these tools to help deliver reader analytics to our authors to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

Analytics/Performance Cookies. JD Supra also uses the following analytic tools to help us analyze the performance of our Website and Services as well as how visitors use our Website and Services:

Google Analytics - For more information on Google Analytics cookies, visit www.google.com/policies. To opt-out of being tracked by Google Analytics across all websites visit http://tools.google.com/dlpage/gaoptout. This will allow you to download and install a Google Analytics cookie-free web browser.

Facebook, Twitter and other Social Network Cookies. Our content pages allow you to share content appearing on our Website and Services to your social media accounts through the "Like," "Tweet," or similar buttons displayed on such pages. To accomplish this Service, we embed code that such third party social networks provide and that we do not control. These buttons know that you are logged in to your social network account and therefore such social networks could also know that you are viewing the JD Supra Website.

Controlling and Deleting Cookies

If you would like to change how a browser uses cookies, including blocking or deleting cookies from the JD Supra Website and Services you can do so by changing the settings in your web browser. To control cookies, most browsers allow you to either accept or reject all cookies, only accept certain types of cookies, or prompt you every time a site wishes to save a cookie. It's also easy to delete cookies that are already saved on your device by a browser.

The processes for controlling and deleting cookies vary depending on which browser you use. To find out how to do so with a particular browser, you can use your browser's "Help" function or alternatively, you can visit http://www.aboutcookies.org which explains, step-by-step, how to control and delete cookies in most browsers.

Updates to This Policy

We may update this cookie policy and our Privacy Policy from time-to-time, particularly as technology changes. You can always check this page for the latest version. We may also notify you of changes to our privacy policy by email.

Contacting JD Supra

If you have any questions about how we use cookies and other tracking technologies, please contact us at: privacy@jdsupra.com.

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